Key points
- All subordinated debt and Additional Tier 1 capital securities/hybrids (AT1) issued by banks since 1 January 2013 come with a number of added risks. These securities are referred to as Basel III-compliant (or “new style”) capital securities
- The predominant additional risk is the “non viability clause” which allows the regulator (APRA in the case of Australian banks) to order subordinated debt or AT1 securities issued post 1 January 2013 to be converted into equity (most likely at a significant capital loss to investors) or written off should the regulator, at their sole discretion, deem that the bank in question is at the point of non-viability
- AT1 securities (and some subordinated debt issues conducted offshore) also come with a mandatory conversion to equity where the Core Equity Tier 1 ratio (or CET1) falls below a pre-determined or contingent level, as set in the issue documentation. For all Australia issues to date, this level has been set at a CET1 of 5.125%. All such securities are by definition contingent convertible (or “CoCo”) capital securities as they have the potential to be converted to equity or written off
- As a result of the mechanisms to enable “non-viability” and CoCo conversion terms, “old style securities” rank above the equivalent “new style” securities in a liquidation scenario
- The additional risks presented in Basel-III compliant capital securities are the same for ASX listed and over the counter (OTC) issues. All things being equal, “new style” Basel III-complaint capital securities are higher risk than the “old style” securities issued pre-1 January 2013, however, they typically trade at a higher credit margin. Further, it is generally viewed that the probability of call at first opportunity of “new style” securities is more a function of economic cost of capital as opposed to the reputational grounds as seen in the past
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Investors should ensure they are aware of these additional risks and assess whether they are being paid sufficient return to compensate
Pursuant to Basel III regulatory developments for global banks, the rules for what constitutes regulatory capital changed on 1 January 2013. For fixed income investors the changes had significant implications for subordinated debt and Additional Tier 1 capital securities/hybrids (AT1) issued from 1 January 2013 onwards. AT1 securities have replaced (or are the new form of) Tier 1 perpetual securities under Basel III rules for regulatory capital.
In Australia these changes were adopted by the local regulator, the Australian Prudential Regulation Authority (APRA) but similar changes were implemented by the vast majority of bank regulators in developed economies across the globe. (Note that while some similarities may exist in insurance regulation, Basel III and the changes detailed below only apply to banks).
Since January 2013 there have been a number of subordinated debt and AT1 issues by Australian banks. For various reasons the majority of the subordinated debt issues have been in the OTC market and all of the AT1 issues have been in the ASX-listed (hybrid) market and this trend is expected to continue.
The following discussion details key differences between the “new style” Basel III-compliant securities and the “old style” subordinated debt and AT1 securities issued pre-1 January 2013 (with the majority issued pre-GFC).
There are four key differences between “new style” and “old style” securities:
1. Non-viability clause
Any new subordinated debt or AT1 security issued after 1 January 2013 must include a non-viability clause. This is the predominant change under Basel III rules for capital securities and states that if the regulator, at its sole discretion, believes an issuer/bank is at the point of “non-viability”, then they can require that any capital securities with the requisite terms in the documentation be written off (the default position) or converted to equity (if the issuer is listed and this is requested by the issuer at the time of structuring the deal). This is a material increase in risk and is viewed as a greater concern for any bank considered to be at the lower end of the credit quality spectrum.
The point of “non-viability” is not defined. In layman’s terms it is when the regulator deems the issuer to be sailing too close to the wind but that may be on capital grounds or liquidity or even due to a high balance of non-performing loans. The key risk here is that unlike contingent convertible clauses in AT1 securities (detailed below) that trigger a capital loss if a pre-determined or contingent trigger is hit (e.g. CET1 ratio falls below 5.125%), the trigger here is at the regulator’s sole discretion (but would be assumed to at a lower CET1 than 5.125%). One probable trigger point would be a government equity injection or similar state support to an ailing bank, something that occurred with many big name banks in Europe in the GFC such as RBS, Lloyds and ING.
The non-viability clause is only contained in new issues conducted from 1 January 2013 onwards. This means that in the event it is triggered, such “new style” issues would be converted to equity (or written off) whereas “old style” subordinated debt and even Tier 1 hybrid issues that do not have such a clause could not be converted. This would effectively make the “old style” securities senior in ranking. While this will only exist for the period that both “old style” and “new style” capital securities exist, it is an important and very relevant additional risk. Further, the lower the credit quality of the issuer, the greater this risk becomes.
The following is an excerpt from the ANZ 25 June 2024 (callable 25 June 2019) subordinated debt issue term sheet, however investors are advised to read the documentation of each issue closely as there can be, and often are, differences in key terms and definitions:
Ranking:
Direct, unsecured, subordinated obligations of the Issuer ranking pari passu among themselves and with all Equal Ranking Securities. Equal Ranking Securities include Tier 2 securities issued after 1 January 2013. Lower Tier 2 capital instruments issued before 1 January 2013 rank senior to Tier 2 securities issued after 1 January 2013.
Point of non-viability:
If a Non-Viability Trigger Event occurs, ANZ will be required to immediately convert some or all of the principal amount of the Notes into Ordinary Shares.
The Notes will convert into ANZ ordinary shares based on the VWAP over the 5 business days prior to the Non-Viability Trigger Event, subject to the Maximum Conversion Number. The “Maximum Conversion Number” is a number calculated by reference to 20% of the Issue Date VWAP (namely the VWAP over the 20 business days prior to the Issue Date).
A “Non-Viability Trigger Event” means the earlier of:
- the issuance to the Issuer of a written determination from APRA that conversion or write-off of Relevant Securities is necessary because, without it, APRA considers that the Issuer would become non-viable; or
- a determination by APRA, notified to the Issuer in writing, that without a public sector injection of capital, or equivalent support, the Issuer would become non-viable
If ANZ is prevented by law, court order or any other reason from converting the Notes within five business days after the conversion date, ANZ will be required to write off some or all of the principal amount of the Notes and immediately and irrevocably terminate the rights of the holders. Investors will lose some or all of the value of their investment and will not receive any compensation.
The mechanics of the “maximum conversion number” (which is typical of the structure of all recent subordinated and AT1 deals) effectively means that should the share price fall more than 80% between the time of the issue of the security and time of conversion, then the investor will face a capital loss. It would be fair to assume that if APRA were enforcing a non-viability clause or a conversion is triggered by CET1 falling below 5.125% (a common term in AT1 securities), that the share price would be severely depressed and a capital loss on conversion very likely.
2. Contingent capital conversion clause (CoCo)
All AT1 securities (and some subordinated debt issues conducted off shore but to date no subordinated debt issues from Australian banks) also come with a mandatory conversion to equity where the Core Equity Tier 1 ratio (or CET1) falls below a pre-determined (or contingent) level as set in the issue documentation. In the case of Australian bank AT1 securities, this has always been set at a CET1 of 5.125%, however some issues conducted by European banks have seen 7.0% and 8.0% trigger levels.
All such securities are by definition contingent convertible (or “CoCo”) capital securities as they have the potential to be converted to equity or written off. The typical structure in Australia has been for an automatic conversion to equity, subject to a “maximum conversion number” that would see investors face a capital loss when the share price has fallen in excess of 80% between issue date and conversion date.
3. Step-up clause
New Basel III rules also explicitly prevent the use of step-up margins on any new regulatory capital instrument such as subordinated debt or AT1 securities. Step-up clauses were seen to be “incentives to call” by the Basel Committee and have been outlawed (see below for further detail).
“Old style” step-up securities issued before the change in capital rules have been given grandfathering relief to still count towards the capital calculations (albeit on a reducing basis) however only until the first call date, after that date their contribution to capital immediately falls to zero. Further, APRA has previously stated “outstanding non-complying instruments [read step-up securities] will be required to be phased-out no later than their first available call date, where one exists”.
The existence of a step-up clause is an important differentiation in a subordinated debt (or Tier 1 hybrid) security. It is a typical feature of “old style” securities and, given the treatment under the revised Basel III and APRA capital rules, provides a strong incentive for the issuer to call at first opportunity. No such incentive exists for “new style” subordinated debt and further, the lack of such a clause is a movement towards economic-based call decisions.
4. Expectation of call
Following on from the step-up discussion above, one of the key thrusts of the new Basel III (and APRA) capital rules is to remove any indication to the market that a capital security is intended to be called at first opportunity. Rather, regulators want issuers to make each call decision on the economic merits of cost versus benefit (i.e. is it cheaper to call and re-issue another similar security and if not the issuer should not exercise their call option).
By removing “incentives to redeem” (including step-up clauses) from the structure of newly issued capital securities, the issuers are being forced by regulators to use an economic rationale for the call decision. Further, investors will no longer be able to rely on reputational grounds for expectation of call at first opportunity. Issuers have been very careful in their marketing of new issues to ensure they do not give investors the expectation that “new style” subordinated debt or AT1 securities will be called at first opportunity.
APRA has even suggested that if an issuer was to request its approval to call a capital security with the intention to replace it with a new issue with a similar structure but at a higher margin, it would decline the request.
It is anticipated that once the “old style” securities, particularly step-up securities, no longer exist in the market that the long held expectation of call at first opportunity will change. Basel III and APRA are pushing for a market where both the issuers and investors expect callable securities to be called only when it is economic for the issuer to do so. We believe the market will make this transition over the next two to three years.
Based on the discussion above, the expectation of call at first opportunity is much stronger for “old style” step-up securities than the “new style” that will be assessed purely on economic grounds.
Conclusion
All subordinated debt and AT1 securities issued by banks since 1 January 2013 come with a number of added risks, including the potential for securities to be converted to equity or written off.
The existence of these additional risks and in particular the difficulty in assessing or hedging against the subjective “point of non-viability” greatly reduces the attractiveness to the wholesale (or over the counter bond) market. In addition, many institutions cannot hold securities that may be converted into equity (although recent issues have sought to address this with an automatic security sale facility upon any conversion). As such, there is limited institutional buying interest, particularly in the Australian AT1 securities.
The market has developed such that the retail ASX listed market has become the preferred home for the higher risk but higher return AT1 securities, many of which are expected to convert to equity rather than being redeemed for cash. Retail investors are seen to be chasing the higher yields from names they know and are less worried by the additional risks posed. While there were a number of ASX listed subordinated bonds in 2012 and early 2013, the more recent issues have all been in the OTC market where institutional investors can command greater liquidity and retail demand has been limited as “hybrid investors” have a preference for the higher yielding AT1 securities.
The additional risks presented in Basel-III compliant capital securities are the same for ASX listed and OTC issues. All things being equal, “new style” Basel III-complaint capital securities are higher risk than the “old style” securities issued pre-1 January 2013 however “new style” securities typically trade at a higher credit margin.
Further, it is generally viewed that the probability of call at first opportunity of “new style” securities is more a function of economic cost of capital as opposed to the reputational grounds as seen in the past
Investors should ensure they are aware of these additional risks and assess whether they are being paid sufficient return to compensate.
Further information on ASX-listed bank hybrids can be found at the MoneySmart section of the ASIC website (web address below):
https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes/bank-hybrid-securities