by
Justin McCarthy | Sep 07, 2011
By Justin McCarthy
On 6 September 2011, APRA released a discussion paper titled “Implementing Basel III capital reforms in Australia”. While Basel III relates to banks and this paper is directed at Authorised Deposit-taking Institution (ADIs), APRA have stated they intend to standardise capital treatment in most areas between banks and insurers. As such many of these comments are deemed relevant to Australian insurers.
While a number of issues were covered in the 45 page paper, we will concentrate on the implications for existing Tier 1 (hybrid) and Tier 2 (subordinated debt) step-up securities, many of which form FIIG’s top relative value recommendations.
As our regular readers and investors will be aware, we believe there is a high probability of all major and regional Australian banks calling their Tier 1 and Tier 2 subordinated step-up securities at first opportunity. This extends to both A$ issues and non-A$ issues. As such we believe non-call risk is low and with a generally high credit opinion of all Australian banks, we are more than comfortable with the excess return investors can gain from moving down the capital structure into Tier 2 and Tier 1 securities. This has formed one of our key investment themes for the last few years.
The above consultation paper does nothing but strengthen our already high confidence levels. While the paper is not yet law (in fact is the first of two consultation papers before the APRA intend redrafting the laws/prudential standards in mid-late 2012), it provides a very clear signal that APRA intend to phase-out all “old style” step-up capital securities at their first call date.
The key “grab” from the consultation paper is as follows:
“outstanding non-complying instruments will be required to be phased-out no later than their first available call date, where one exists”.
As previously written, the revised Basel III rules and initial interpretations from APRA stated that Tier 1 and Tier 2 step-up securities would get no capital weighting towards the capital ratio calculations once they pass their step-up date. We viewed this as a strong incentive for the banks to call at first opportunity. However, this paper uses even stronger language in saying such non-complying securities “will be required to be phased-out no later than their first available call date.”
Note that all step-up securities are by definition non-complying as step-ups are explicitly excluded under the new Basel III and APRA capital rules.
The wording even suggests that APRA may force or strongly persuade ADIs to call these old style securities in the unlikely event an ADI didn’t plan to call at the first opportunity.
Accordingly, we continue to favour investments in Tier 1 and Tier 2 securities with a step-up issued by Australian banks and insurance companies. These “old style” securities are expected to be called at first opportunity, will continue to benefit from the scarcity factor as more and more as called (with no further step-up securities being issued) and are typically trading at material discounts to face value. This scarcity factor, together with a reduction in the market’s assessment of call risk is expected to see these securities increase in value over the medium term.
In addition to the favourable structural issues, we are also very comfortable with the credit risk of the vast majority of Australian banks and insurers and hence comfortable with the slightly higher risk of moving down the capital structure.
With no apparent difference between APRA’s view on the phase out of step-up Tier 2 subordinated debt and Tier 1 hybrids, the lower ranking Tier 1 securities offer the best value in most situations.
At the time of writing, our favoured Australian bonds include:
- The National Capital Instruments - a Tier 1 step-up security with a first call date in 2016, currently trading at an expected yield to call of circa 8.4% (restricted to wholesale clients with a minimum parcel size of $500,000).
- A number of major bank Tier 1 securities issued in US$, GBP or € now trading at margins as wide as 5% - 6% over relevant swap rates, the ANZ € callable 2014 among the best value (but again for wholesale clients only).
- The Tier 2 subordinated debt of the Suncorp Group, particularly the insurance divisions, including Vero Insurance.
All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.
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