Australian bank Hybrids, like CBA Perls or Westpac Capital Notes, have been a popular part of Australian investing since they came on the scene in 2012. They have performed very admirably for investors, but they are not performing the capital adequacy role they were designed for. As such, in December last year, APRA confirmed that Australian banks would no longer be able to use so-called “Hybrid Capital” or “AT1s” as part of their capital structure. This was not a surprise as the move had been telegraphed in September. But it does leave the market with something of a quandary.
The bank hybrid market is very large: there’s consistently been between $A35bn and $A40bn on issue for the last five years. This will now run-off over coming years with the regulator telling banks, essentially, that the hybrids will remain in existence, but must be called at the first available opportunity. We see the last existing call date as being in December 2031. This will create a fairly steep and nearly linear run-down in amounts outstanding (see Figure 1).
The amount invested will drop from $A35bn now to $A0 in six years. That’s a lot of money to be returned to investors (and we’re not even counting the interest). Where is that money going to be reinvested? Like almost every question, the answer is that no single new investment will fill the void entirely, but the most likely place for a majority of that cash to land is a slightly different part of the bank capital structure known as Tier 2 subordinated bonds. These subordinated bonds are issued by banks and, while different in structure, are quite near substitutes for the AT1 hybrids that have been discontinued. In fact, the APRA rule change that discontinued hybrids also required banks to issue significantly more Tier 2 subordinated bonds – so there will be investors looking to buy bonds just while banks are looking to sell.
But what are Tier 2 subordinated bonds? Taking a step back, let’s look at what the differences are between regular shares, hybrids (AT1), Tier 2 bonds and regular bonds in the capital structure of a bank.
Owning a share is ownership of a small part of a company. This gives the owner the right to receive dividends paid out of the profits of the company as the board of directors sees fit. It also gives shareowners the right to participate if the whole of the company is sold. Shares are long-term investments that carry a reasonably high amount of risk. If the company is successful, the total return can be very large. It’s possible, though rare, to double, treble or even quintuple your money in a relatively short space of time. Of course, if the company isn’t successful the value can drop to zero, too. There’s a wide variety of outcomes, which is why shares are referred to as risky investments. There’s no guarantee of when, or even if, you will get your money back.
At the other end of the spectrum is regular debt. Debt investors in banks do not own part of the bank but are instead owed a specific sum of money back, with interest. Regular debt has very strict rules that dictate exactly how much is to be paid and on which precise days. If the bank doesn’t pay the exact amount, then the bank can be forced into default. Regular debt owners get a very clear and precise definition of how much they are getting paid and when. If the bank hits difficulties and suspends or lowers dividend payments, the debt holders still get the same pre-agreed amount of interest. But that surety comes with a catch. That precisely described interest payment is both the minimum and the maximum that a debt owner can receive from the bank. If the bank does very well, makes large profits, and decides to increase dividends, the debt holder still receives the same amount of interest. Only if the bank fully defaults does the debt investor not receive their specified payment.
Both AT1 hybrids and Tier 2 subordinated bonds sit between these two extremes, having both equity and debt features. AT1 hybrids are more like equity, with some debt features. Meanwhile the Tier 2 subordinated bonds are more like debt, with some equity features. In both cases, there is still a maximum possible return, but that return is higher than for regular senior debt and is supposed to recompense the investor for increased risk.
Bank AT1 hybrids were supposed to be deeply subordinated. In the event that the bank did poorly, the hybrids were supposed to be able to have coupons suspended and, if that wasn’t enough, the banks would write down the hybrids to ease their debt burden before the bank failed. Notice these are equity-like features – the ability to suspend interest is like the ability to suspend dividends, and the ability for hybrid investors to take a capital loss is clearly like equity. At least in theory the hybrids are equity-like. Although suspending coupons might seem like a good plan to give a bank some breathing room, it doesn’t work in practice. A bank with a small cash-flow problem that announces they are going to suspend interest payments is now a bank with a large confidence problem and most likely suffering a bank run. Also, since Australian AT1 hybrids were mostly owned by retirees and non-professional investors, it made it very difficult, politically, to enforce the write-downs in the case of stress but before bank failure. This meant that hybrids were failing their two main capital adequacy intentions: they neither eased interest costs in times of stress, nor provided a reliable route to lowering total debt before failure. Hence, APRA has sought to move away from AT1 hybrids.
Tier 2 bonds are also exposed to write-downs if the bank that issues them fails, but the key difference between AT1 hybrids and Tier 2 subordinated bonds is that for Tier 1 hybrids, the write-down can happen before the bank fails as a mechanism to prop up the bank and help it continue as a going concern. However, for Tier 2 bonds, the write-downs only happen in the event of an actual failure. This is a subtle point, but it makes quite a difference to the risk profile. As a result, Tier 2 bonds have slightly less risk in them than AT1 hybrids and so usually have a very slightly lower yield. That historical difference in yield has eased recently. Investors want to keep hold of hybrids since they are not going to be replaced and, also, the APRA directive about calling them as soon as possible lowers the risk in hybrids, making them look more like T2 bonds.
Once APRA’s proposed changes take place, large banks will begin the task of replacing the current 1.5% capital composed of AT1s with 1.25% capital composed of AT2s and 0.25% common equity (that is, shares). Smaller banks will simply replace AT1 hybrids with Tier 2 subordinated bonds. This process means that Tier 2 subordinated bonds will be lower in the banks’ capital structure but protected by more equity. This is a slight increase in risk in Tier 2 bonds which will likely, over time, see yields rise a touch.
Although bank hybrids have been stagnating in total issuance of late, bank Tier 2 subordinated bonds have been rising sharply with a great deal more local issuance and some foreign issuers also coming to Australian markets. Using only the conservative assumption that banks replace existing Tier 2 debt and then replace the outstanding Hybrids with Tier 2 (in a 5/6ths ratio to mimic the 1.50% to 1.25%) there will be a very large amount of Tier 2 issuance in coming years. Conservatively, it looks like nearly $50bn over the next five years and even larger than that once we factor in growth in the system as a whole.
The biggest difference between subordinated Tier 2 bonds and AT1 hybrids is not their yields – though there is a small difference there. As I write, a new deal is in progress from HSBC for a bond with a call date in 5 years’ time that is offering a yield in the mid-5% range.
The biggest difference is that Tier 2 bonds pay regular cash as coupons, there is no fancy accounting or complications regarding franking credits. The Tier 2 bonds pay their interest rates as regular cash.
We are expecting a large flow-over of investors out of hybrids into Tier 2 subordinated bonds in coming years. Investors in bank hybrids will find that there is very unlikely to be any new issuance of this type of structure. Instead, as the hybrids mature new investments will need to be found. At the same time, the banks will be issuing large volumes of Tier 2 bonds, which will likely offer strong yields (well above term deposits – particularly if the RBA keeps cutting rates). This makes Tier 2 bonds well positioned to be a much larger part of the market.