Major Banks Issue Over $7Bn in Tier 2 Subordinated Bonds
In early July, APRA confirmed that the four major banks will be required to increase their total capital ratios by 3 percentage points (down from the initial recommended 4 - 5 percentage points) by 1 January 2024. In simple terms, this is likely to see an additional $50Bn of subordinated debt issued by the Aussie majors between now and 1 January 2024.
With a significant increase in supply expected, spreads on major bank subordinated debt widened by ~0.15% on the day of the announcement, but by the end of the following day, had retraced that move. In the three weeks since there have been large issues by ANZ, NAB and Westpac (totaling ~ A$7.1M on top of the A$1Bn NAB printed in May). CBA are expected to launch a deal in August. All the new issues have been met with very strong demand (and solid new issue premiums) and have performed very well in the secondary market
Assuming CBA does a large issue shortly after its results, all four major banks will have essentially met their increased T2 issuance targets for 2019 in the space of just 4-5 weeks. We believe that the task at hand of raising ~$50bn of additional subordinated debt by January 2024 is very manageable for the four majors, and expect it will create value and superior liquidity in the subordinated bond market in the coming months and years.
It is reasonable to assume that the major banks will continue to tap the US market, where demand has been extremely strong and they have been able to place longer dated 10-year call and 20-year bullet subordinated debt.
The AUD market may see an increase in ASX listed subordinated issues, potentially in 2020-21, and/or an increase in the average length of new AUD Tier 2. The AUD market has traditionally seen 10-year issues that are callable after five (10NC5), however we believe that over time there will be an increase or push for 15-year issues that are callable after ten (15NC10).
Investment grade subordinated bonds are considered a cornerstone of any fixed income portfolio and we will continue to monitor the market for value in both primary and secondary markets.
We are particularly focused on new premiums by virtue of large size, new structure and/or new market (e.g. ASX).
Implications for NABHAs and major bank ‘Discos’
There are also implications for the legacy securities such as the Tier 1 NABHAs and the major bank ‘Discos’ which currently count as Tier 2 capital (except the CBA Disco which is treated as Tier 1). With ~$50bn of new Tier 2 capital required to be raised and the fact that all these legacy securities will no longer count at all towards capital from 1 January 2022, there is extra incentive for the major banks to call or rollover these securities and replace them with effective, Basel III compliant Tier 2 capital. A large ASX-listed subordinated bond is a possible refinance avenue for the NABHAs and an exchange offer could be an option for the USD denominated Discos in the years leading up to the 1 January 2022 deadline.
NABHA Investment Thesis Updated
Back in June last year, we provided a detailed Investment Thesis for the NABHAs.
Whilst much of the rationale remains unchanged, the recent APRA announcement regarding subordinated debt targets by 2024 and other market factors have slightly changed our call probabilities. Further, the continued march higher in price (NABHAs closed at $92.27, down just 49c on the day despite going 72.8c ex-distribution) has led to the following change in our thesis and yields to various call dates.
As mentioned above, the requirement of the major banks to increase Tier 2 subordinated debt increases the probability of a ‘roll’ of this large A$2bn issue into a new style Basel III compliant AT1 hybrid or possibly an ASX listed subordinated bond. AT1 and Subordinated bond new issue margins are at (or very near) the lows seen since Basel III came into force in 2013. A new ASX-listed AT1 hybrid with a five-year call would be possible at a margin of below +300bps in the current market. With BBSW at just 1.01% and falling, the total cost in the medium term is likely to be less than 4.0%, with 30% of that paid by franking credits, hence a cash cost of less than 2.8%. A subordinated bond could be issued at even lower margins and whilst franking is not permitted, it is tax deductible. As such, the environment is very receptive of cheap replacement funding. There is plenty of demand as measured by the size of the recent book-builds. This factor potentially brings forward a decision to deal will the NABHAs by NAB Treasury.
However, the NAHBAs are still very effective capital with 93% counting towards Tier 1 ratios in 2019, falling to 62% in 2020 and 31% in 2021 (see table below), suggesting a call/’roll’ closer to 2021 would be more sensible.
Weighing all the factors we now have the following call probabilities by year (with the yield to call for various dates in brackets):
By comparison, new style major bank AT1s with call dates in late 2021 are trading with a yield to call of circa 2.8%.
The NABHAs have been our number 1 trade for almost three years and we continue to hold high conviction that investors will be able to exit at par before 2022. Despite the clean price now rising to a post GFC high of $92.27 we still see capital price upside from this Baa2/BBB- security issued by a major bank.
Cameron Window, BGC