In making the decision whether to exercise the call option, the bank or insurance company will consider:
- The cost of replacement capital
- Market reputation
- The regulatory environment at the call date
1. Cost to reissue
The issuer will examine the cost to reissue their debt at the call date versus keeping the current debt outstanding. This will depend on any step-ups in the existing security and credit markets at the time of call.
Step-ups are an increase in the credit margin (typically over 3 month BBSW) that occur if a security is not called to compensate investors for the fact the security was not called. Step-ups are contained in most but not all subordinated debt and Tier 1 hybrids issued pre-2010 but are now outlawed in the case of banks under Basel III. While not banned for insurers in many jurisdictions, their use has been greatly reduced in new insurance debt issues.
As we will discuss below, whether or not an issue has a step-up is extremely important in our assessment of call risk, particularly for banks.
Typically speaking, subordinated debt or Tier 1 hybrids issued prior to the GFC are very cheap funding (even after a step-up margin is added). From an economic point of view, extending many of these pre-GFC issues would be significantly cheaper than replacement funding in the current market.
As an example, Macquarie Bank issued a ten year non-call five year subordinated bond in May 2007 with a coupon of 35bps over BBSW and if not called in May 2012 it would have stepped-up to a new margin of just 85bps over BBSW. Had Macquarie Bank raised a new subordinated bond in May 2012, we estimate the cost would have been at least 375bps over BBSW given the majors had, at that time raised ASX listed subordinated debt at a margin of +275bps. Despite the low cost to extend, Macquarie Bank decided to call the bond, mainly on reputation and regulatory grounds as detailed below.
Conversely subordinated debt and Tier 1 issues raised post GFC typically have very high credit margins and large step-ups if not called which provide a strong economic incentive to be called and replaced with cheaper funding. For example Bank of Queensland issued a ten year non-call five year subordinated bond in June 2008 with a coupon of 310bps over BBSW. If not called in June 2013 it will step-up to a new margin of 410bps over BBSW making it expensive funding and more likely to be called and replaced with something cheaper.
With the majority of existing subordinated debt and particularly Tier 1 hybrids issued pre-GFC, the cost of funding assessment provides an economic case for banks and insurers to extend the maturity and pay a relatively small “penalty rate”. However, this argument is overshadowed by the two remaining opposing factors.
2. Reputation and access to market
In the professional market there is often an expectation that issuers will exercise their call option at the first available date. This applies to the subordinated bond and international Tier 1 markets. When an issuer's bonds were initially sold to investors it was based on pricing the credit risk to the call date so any extension beyond this date means investors have not received adequate compensation (in the form of coupon margins) for the increased term (although Basel III and APRA are trying to remove this expectation of call for future callable bond issues).
As the issuers of these securities are banks and insurers and require ongoing access to the global debt markets it would be very damaging for an issuer's reputation to not exercise their call option. An example of this is Deutsche Bank who did not call one of their bonds during the global financial crisis and found it difficult and more expensive to issue new bonds when they returned to the market.
This reputational risk is not as prevalent in the retail hybrid market as it is in the professional institutional market where OTC bonds trade (nor the corporate market where the companies are less reliant on ongoing access to debt markets).
This is currently the most important factor for banks and insurers in the call decision. We often hear Australian banks and insurers saying they are not going to be the first institution in Australia not to call a step-up security (note: there have been examples of Australian bank non step-up securities not being redeemed at first call please see the article in this week’s WIRE “Financial institutions call risk by jurisdiction”). They don’t want the damage to their reputation.
However, the big risk here is that a number of institutions make the decision not to call and then safety in numbers may mean the norm becomes that no one calls and the market can’t single out specific issuers for not calling. In Europe the stigma attached to not calling has reduced somewhat as a number of organisations have been prevented by regulators or in the case of Ireland, Italy and Spain, simply unable to afford to call. In 2012, only 50% of callable securities were called at first opportunity in Europe, although that statistic can be explained to some extent by a large number of smaller or weaker banks that had callable securities come up in 2012 as well as a number of the European banks and insurers that received bail-outs in the GFC. In the main, large and strong institutions continue to call in most cases, Deutsche Bank being the main exception. It is this increasing propensity not to call that has seen us increase our call risk assessment recently, particularly for international banks and insurers.
In Australia, the reputational risk remains high with no major bank, regional bank or large insurance company not calling their step-up callable securities.
3. Regulatory environment
All regulatory capital instruments i.e. Tier 1 hybrids and Tier 2 subordinated debt must first receive regulatory approval before they can be called. So it is very important to note that if a bank or insurance company is struggling a little and/or the regulator is concerned with the institutions’ level of capital, they may not allow a callable security to be redeemed at its first date.
Since the GFC a number of European banks and insurers have been prevented from calling by regulators. In particular, any group that received a bailout or capital injection from a government has since been prevented from calling subordinated debt and Tier 1 hybrid securities for periods of up to three years.
There are also changes to prudential requirements for banks and insurers that alter the classification of the security as regulatory capital that may require the issuer to exercise their call option.
Bank regulatory environment
From 1 January 2013 Basel III has established that any Tier 1 hybrid or Tier 2 subordinated debt issue that contains a step-up will be ineligible as regulatory capital once it passes its first call date.
Back in September 2011 we wrote an article "APRA announce further details on capital - Positive for step-ups" which included the following statement from APRA regarding its intention to phase-out all "old style" step-up capital securities at their first call date which includes both subordinated debt and Tier 1 hybrids.
Outstanding non-complying instruments will be required to be phased-out no later than their first available call date, where one exists
Under Basel III and APRA's capital standards, bank step-up securities get no capital weighting towards the capital ratio calculations once they pass their step-up date. However, APRA have used even stronger language than the global Basel III standards in saying such non-complying securities "will be required to be phased-out no later than their first available call date."
There are a number of Tier 1 hybrid and Tier 2 subordinated debt securities that do not have step-up clauses. We view these securities less likely to be called on all three grounds:
- They are typically cheap to maintain as were generally issued pre-GFC at low credit margins that don’t alter once the first call date has passed
- The reputation risk is lower as the professional institutional market did not have the same expectation of call at first opportunity as the step-up securities, although retail investors may have had the same expectations regarding first call as the step-ups
- The regulatory environment is not as harsh in its treatment of these hybrids. While non step-up hybrids will collectively lose a 10% contribution to capital per year over the next ten years and this is an incentive to call and reissue specific loss absorbing hybrids, there remains enough scope to leave cheap securities outstanding and make the most of lower funding costs
There also exists an additional APRA capital rule that has implications for subordinated debt issues only (and is similar in other jurisdictions). Tier 2 subordinated debt securities contribute to the calculation of a bank or insurance company’s regulatory capital ratios. However, this weighting falls by 20% each year in the last four years prior to maturity. As such it’s weighting and capital contribution in the total capital ratio calculation falls as maturity approaches. This typically kicks in one year after the first call date and in the unlikely event a subordinated debt issue is not called at first opportunity does provide some incentive to call in the ensuing years and before legal final maturity.
Accounting and tax treatment of the security may also influence an issuer's decision to call securities.
In Australia all major and regional banks and all well known insurers have continued to call every step-up subordinated debt and Tier 1 hybrid security (in A$ and non-A$) at first opportunity, to our knowledge. We expect this situation to continue. (Note, there have been some smaller credit unions that did not call subordinated debt at first opportunity and a small number of non step-up callable securities have gone past their first call date).
Insurance regulatory environment
While the regulatory picture is clear in the banking industry, it is far less certain for insurers, particularly those based offshore.
Solvency II, loosely the European Union’s equivalent of Basel III but for insurers, has seen numerous delays and changes to proposed key regulations. In late 2012, commencement of Solvency II regulation was officially delayed to 1 January 2014, however many commentators believe even that date is likely to be pushed back. The regulators appear to be a long way from agreement and being in a position to propose final capital rules (amongst many other aspects).
Until recently, our very broad assumption was that Solvency II would adopt many of the same capital rules as Basel III. In particular, we were of the view that just like banks, the use of step-up securities for insurers would be outlawed and more importantly, that if an existing step-up security went past its call date it would not count towards that insurer’s capital ratios. We have now significantly reduced our confidence in this on two levels:
- If the step-up clause will be adopted in the final rules
- The commencement date – it is unlikely to be implemented and ready by 2014 and in our view may be 2015 or beyond
On balance we still expect the likes of Vero Insurance (Suncorp), National Wealth Management, Swiss Re and AXA SA to call at first opportunity primarily on reputation grounds. However, the regulatory impetus for them to do so is somewhat uncertain, with AXA SA the most impacted given their direct link to Solvency II as a European Union insurer.
Note that Switzerland/Swiss Re is not in the EU and have their own regulations which are in place and do allow the continuation of step-ups. However, we remain confident that Swiss Re will call at the first opportunity based on reputation grounds.
Likewise the Australian insurers are governed by APRA, with visibility of regulatory developments higher than that for Solvency II and reputation risk also remains high in this market.
However, European insurers have both a demonstrated increase in the incidence of non-call and lower or unclear direction under current regulations making the assessment of call risk for these entities far more difficult.
Rollover or exchange for a new security - this is another option for issuers and one that we have witnessed in Europe to the detriment of investors. Distressed European banks have called or exchanged the securities at the prevailing market value resulting in investors crystallising losses. In institutional markets this damages an issuer's reputation as the exchange favours the issuer and is often referred to as a coercive exchange. In Australia, Goodman's have used this option despite continuing to be rated and this precedence is not one that we would like to see become commonplace in the hybrid market.
Non-financial corporate and the decision to call
Corporate callable debt products, many of which are ASX listed, are a different kettle of fish. With a significantly lower reputational risk assigned to non-call, the corporate world is conducted on a cost-benefit basis. If the new stepped-up margin is cheaper than what the corporate can refinance, then more than likely the issue will not be called and the margin will step-up. We have seen that with a number of ASX listed corporate hybrids over recent years such as MXUPA, AAZPB, SVWPA and ELDPA.
If the corporate is rated by a rating agency, there can also be implications on the rating from whether or not the issuer calls but in general we believe the incentive from a rating basis to call is low.