Last week, Suncorp launched a new ASX listed subordinated debt deal, the first such Basel III compliant deal under the new APRA capital rules that commenced on 1^st January 2013. In this article we take a closer look at key differences between the “new-style” and “old-style” subordinated debt and Tier 1 hybrid securities.

There are three key differences between “new-style” and “old-style” subordinated debt:

1. Step-up clause

New Basel III rules (which have been adopted by APRA) explicitly prevent the use of step-up margins on any new regulatory capital instrument such as subordinated debt or Tier 1 hybrids. 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.

1. 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 to 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 Tier 1 hybrids will be called at first opportunity.

APRA have 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, they 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 three to four 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.

1. Non-viability clause

Any new subordinated debt (or Tier 1 hybrid) security issued after 1^st January 2013 by an APRA regulated entity must include a “non-viability clause”. This is another of the sweeping changes under Basel III (and again adopted by APRA) and states that if the regulator at its sole discretion believes an issuer 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 for “new-style” subordinated debt in particular and worthy of further assessment.

Firstly, 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 the recent “bail-in” or write-off clauses in Tier 1 hybrid securities that trigger a capital loss or haircut if a pre-determined trigger is hit (e.g. Core Equity Tier 1 ratio falls below 5.125%), the trigger here is at the regulator’s sole discretion. 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.

Secondly, it is only new issues post 1 January 2013 that have this clause (with a few exceptions). This means that in the event it is triggered, new issues such as the Suncorp ASX listed subordinated bond could be converted to equity where “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 that in some ways is closer to Tier 1 hybrid risk than traditional subordinated debt risk. Further, the lower the credit quality of the issuer, the greater this risk becomes. It could be argued that the major banks could get away with this risk being seen as not particularly onerous but for the smaller regional banks it becomes a greater concern.

Lastly, the existence of these additional risks and in particular the difficulty in assessing or hedging again 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 there does seem to be some innovative solutions being suggested in the Suncorp deal). As such, there is limited intuitional buying interest. A cynical view would be to suggest that the retail listed market is the preferred home for such “new-style” securities as retail investors are less aware of the differences in risk and rather simply concentrate on comparative returns to other banks products such as term deposits and listed subordinated debt and Tier 1 hybrid securities.

Conclusion

The new Suncorp subordinated bond (with a first call date of November 2018 and legal maturity of November 2023) is expected to have a margin set at the lower end of the quoted range of 3mBBSW + 285bp - 310bp. Whilst there are a number of additional risks in the “new-style” subordinated debt issue, investors are being somewhat compensated for these risks when compared to more recent major bank subordinated deals that are similar in structure but do not include the non-viability clause. These listed and over the counter subordinated bonds are currently offered at a credit margin of anywhere between 130bp and 205bp over the 3mBBSW.

However, when compared with the existing “old-style” subordinated debt issued by Vero Insurance (wholly owned by Suncorp) the relatively small increase in margin for the longer term to call and additional risks detailed above suggest the new deal may be a little skinny. The existing Vero Insurance bonds are currently offered at a margin of circa +200bp for the 2014 call, +215bp for the 2015 call and +240bp for the 2016 call. Better still is the GBP Suncorp Insurance Fund (guaranteed by Vero Insurance) that has a 2017 call date is offered at a significantly wider margin of circa +400bp.

Notwithstanding the margin on offer for the new Suncorp deal and the differential between the new issue and the existing Vero Insurance subordinated debt, our preference remains for the “old-style” subordinated debt and particularly Tier 1 hybrid securities on a risk-reward basis. This due to two key factors being (1) greater clarity on call/chance of call at first opportunity and (2) the fact the “old-style” securities do not have non-viability clauses.

In particular we continue to see value in the following securities, all of which are only available to wholesale clients:

• National Capital Instruments (“old-style” Tier 1 hybrid) – NAB risk and expected call date of September 2016 offered at circa 3mBBSW +275bp (NOTE: as highlighted previously in our de-risk and diversify strategy, National Wealth Management Holdings subordinated bonds appear to be expensive, with little upside. Investors should consider switching into parent company NAB or any of the other securities below and achieving a pick-up in yield, albeit moving from subordinated debt to Tier 1 level)
• Swiss Re (“old-style” Tier 1 hybrid) – very strong credit with expected call date in May 2017. FRN is currently offered at circa 6mBBSW +320bp and the fixed around 20bp higher at +340bp
• Rabobank (“old-style” Tier 1 hybrid) – arguably the world’s strongest bank and less than two years to the expected call date of December 2014. FRN appears particularly good value at circa 3mBBSW +254bp or yield to call of 5.43%. The fixed rate is offered at circa +227bp or yield to call of 5.16%. May suit investors looking to park money for less than two years but at significantly better returns than available term deposit rates
• GBP Suncorp Insurance Fund/Vero Insurance 2017 call (“old-style” subordinated bond) – as highlighted in our de-risk and diversify strategy, we generally believe that subordinated debt issues of both domestic and foreign banks are fully priced. There is generally little upside given when lower risk senior debt or term deposits are trading, however if there was to be a bout of risk off we expect that there could be a material level of price weakness on these subordinated bonds. The exception to this rule is non-AUD subordinated and Tier 1 securities of Australian banks and insurance companies. If investors did want to go into an “old-style” subordinated debt investment rather than one of the three Tier 1 hybrid securities above, the one issue that does appear to be the most attractive is the GBP Suncorp Insurance Fund/Vero Insurance 2017 call, 6.25% fixed rate subordinated bond that is offered at a credit margin of circa +400bp. There are also a number of attractive Tier 1 securities in various currencies that exhibit strong value. (However, these are only available to wholesale investors and raise foreign currency considerations).

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities