Value in T2 vs AT1

• T2 credit margins on offer are closing in on those of AT1s, a security that sits subordinate to T2 in a bank’s capital structure and is heavily bought by non-wholesale investors.
• Clients would benefit switching out of the AT1 major bank hybrids into T2 major bank securities. T2 is lower risk (higher up in the capital structure), has better investor protections, and one gets almost the same credit margin (return).
• The constant chase for yield/demand and expectation of higher supply in T2 has seen the margins between AT1/T2 compress significantly. However, now would be a good time to reallocate given the risk/return prospects.
• We expect to see the contracted differential between AT1 and T2 remain in the near term. We see more risk in AT1 securities over the next 12-24 months once investor demand is gorged with new issues and domestic rates (mainly 3m BBSW) begin to rise this year.

For the avoidance of doubt:

• T2 = Tier 2
• AT1 = Additional Tier 1
• B3 = Basel III

T2 credit margins on offer are closing in on those of AT1s, a security that sits subordinate to T2 in a bank’s capital structure. This is an interesting dynamic and begs the case for investors to look to switch out of AT1s into T2s. T2 is lower risk (higher up in the capital structure), has better investor protections, and one gets almost the same credit margin (return).

CBA issued a T2 capital instrument last week with the wholesale 10 year, non-call 5 year security issued at a credit margin of 1.90%. Had CBA issued just three months ago, the margin would have been under 1.5%.

Source: Bloomberg

Historically, a good guide is to look at the ratios between B3 T2 and B3 AT1, as well as ratios between B3 T2 and Senior Debt. While the B3 T2/Senior Debt ratio (green line) has been stable over the past three months, the B3 AT1/B3 T2 ratio (green line) has significantly reduced and been reducing over the past six months. Currently, the B3 AT1/B3 T2 ratio (green line) sits at the 1.25-1.5x mark and thus B3 AT1 securities are looking relatively more expensive versus B3 T2 securities.

Using CBA’s listed AT1 security (CBAPK – issued March 2022) as the closest comparison to the new CBA T2 issue, we see that the current credit margin on this security is 2.60%, with a first call in June 2029 (seven years to call).

Taking off 20bps for the additional two years, this represents only a 50bps premium from T2 to AT1. Over the last ten years this premium has averaged around 150bps. However, it has also been above 300bps at various times of heightened volatility. Thus, this current contracted differential is unusual.

Source: Bloomberg

A major reason for this contraction has been that the buyer base for T2 tends to be wholesale investors, while the AT1 market tends to be dominated by retail investors. Wholesale investors care more about the mark to market impact of their holdings and can be more sensitive to economic/global factors (except interest rates, as hybrids are floating rate instruments) versus retail investors, who tend to hold to the call date without a need to mark to market their holdings.

Normally this disconnect would sort itself out over time, but there are other factors at play currently:

• Capital requirements expected by the Australian Prudential Regulation Authority (APRA) over the next few years will incorporate more issuance of T2 – posing supply concerns versus AT1; and
• The recently implemented Design and Distribution Obligations legislation (DDO) means non-wholesale investors need to wait until the AT1 issue lists before buying. This creates extra demand on the first day of listing and has seen AT1 credit margins contract quickly off-the-break.

Thus, we expect to see the contracted differential between AT1 and T2 to remain in the near term. We see more risk in AT1 securities over the next 12-24 months once investor demand is gorged with new issues and domestic rates (mainly 3m BBSW) begin to rise this year.

Please speak to an IAM representative who can assist with liquidity in both the unlisted T2 and listed AT1 market.

Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.

Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.

Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.

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