Extension risk is a feature of callable securities and it’s important to be aware of this risk otherwise it could leave a big hole in your pocket. We highlight Australian securities with similar features that every investor should understand
After Halloween, fixed income investors got a big fright on Tuesday 1 November 2016, as Standard Chartered Bank announced it would not exercise an early redemption on its US$750m perpetual preferred notes, otherwise known as Additional Tier 1 hybrids. These hybrids were callable in January 2017 and investors had wrongly assumed that the bank would redeem them at the first opportunity.
The result – the hybrids dropped $13 to $84 from a past high of $97 per $100 face value.
At the moment, investors in these Standard Chartered hybrids are receiving an interest payment (coupon) of approximately 6.4%, but the coupon will step down in January to about 2.4% (which is 3 month LIBOR + 151bps). The next call date is in 2027. The head of capital management at Standard Chartered said, “It’s an unusual security to have such a low reset coupon so we believe that there isn’t that much read-across to the group’s other AT1 instruments.”
From January, the Standard Chartered hybrids not only have a lower coupon but – attractively for the bank – will still count as Tier 1 capital (the most attractive) until 2021 and then Tier 2.
Are other bank hybrids likely to be impacted?
In a word, yes.
The securities that are most likely to be affected are perpetual non call 10 years and Additional Tier 1 (AT1) hybrids issued pre GFC that have a low coupon reset. In these cases, it is uneconomical – that is more expensive – for banks to call these securities and replace them at current higher market pricing.
However, the decision by a bank to call or not call is not as simple as the pure cost of leaving the hybrids outstanding. It has to be weighed against potential reputational damage that may be caused; investors will be more cautious about buying these types of securities from that bank in the future, and will likely expect the bank to pay a higher rate of interest to compensate them.
Another factor that increases the likelihood of a bank leaving the securities outstanding is the bank’s financial strength. The weaker the bank, the less likely the bank will call the bonds. For a weaker bank, a lower coupon instrument will be a relatively more attractive proposition.
There has been speculation from European credit analysts that Commerzbank and RBS may be likely candidates to follow Standard Chartered’s lead and not call securities when expected.
In that regard, Commerzbank’s CFO said, “From today’s perspective, I don’t know why I would buy them back […] we’re very comfortably set up in regards to funding at the moment.” As a result on Friday, Commerzbank’s EUR416m of 6.352% notes fell by as much as €8 to €91.
Other Tier 1s in the Australian market that have a similar structure include the Swiss Re $300m junior subordinated perpetual floating rate notes (FRNs), callable in May 2017. At the moment, the securities pay a coupon of about 7.64% but if they are not called, the coupon would step down to six month BBSW + 217bps, or 4.17%. Royal Women’s Hospital (RWH) $148m secured FRN matures in March 2021, but is callable in March 2017. If the RWH FRNs are not called, the current 6.2% coupon drops down to one month BBSW + 120bps or just 2.83%.
However these securities are given as examples only and we expect them to be called. There is no suggestion that either Swiss Re or RWH will not call their respective bonds at the next call date.
However, the recent examples of Standard Chartered and Commerzbank highlight extension risk and once again reinforce the lesson that investors should fully read and understand the documents. This is especially true for Australian bank hybrids, which have terms in the documentation that are yet to be tested in a stressed financial environment.