How to make 10% with a major bank guarantee

There are strong underlying reasons why Tier 2 sub debt credit spreads (5 year equiv) could rally into the low 100bps from the current 170bps credit spreads over the course of the next financial year. Current Tier 1 securities such as listed hybrids, offer credit spreads (5 year equiv) at 220bps (which include franking) which seems incredibly tight for the risk going forward. For indicative purposes, if you buy a Tier 2 sub debt at 170 credit spread (5 year equiv) now and Tier 2 margins go into 100 credit spread in 1-years’ time, this equates to an annualised return of 10% given a 6% coupon. We advise clients take this opportunity to either participate outright in the new WSTP T2 or switch out from Aussie T1s and into T2s, based on risk/return dynamics.

Ratings are now in the A bucket.

Recent upgrades by rating agencies have now pushed T2 sub debt to A3 (Moody’s) | A- (S&P Global Ratings) | A- (Fitch) which places them three notches above T1 instruments. Three-notches = 50bps differential = mispriced.

Demand/Supply T2 supply.

The major banks are largely done on T2 sub debt issuance for this year (outside of ANZ). Alongside new institutional support for the T2 product (with ratings now in the A bucket), this should see increased demand versus prior years and place downward pressure on credit spreads to perform.

APRA.

APRA has made it very clear that they want to distinguish the risk profile of T2 sub debt versus T1 in line with other offshore banking jurisdictions. This will mean that T1 becomes more equity-like to preserve capital buffers, T2 sub debt becomes more debt-like and quasi senior unsecured debt.

Stress Testing.

APRA recently released a speech by Chair John Lonsdale at the AFR Banking Summit titled “Severe but plausible: Taking a wider view of risk”. The main highlight was details around APRA’s ADI stress testing. All banks incurred a three-notch downgrade from the rating agencies. APRA reported that of the 11 banks tested, “all had sufficient capital to withstand the severe downturn and support an economic recovery.” Specifically, CET1 fell -330 bps toward 9.0%, chewing through capital buffers. Note – Common Equity Tier-1 (CET1) consists of ordinary share capital, retained earnings, and T1 capital. So T1 (or hybrids) were chewed through in the process of stress tests, and credit losses were incurred, with profits and dividends falling significantly. Importantly, no interest payments on T2 sub debt or T2 refinancing needs were missed, but dividends were heavily curtailed.

Relative Value.

T2 sub debt credit spreads (5 year equiv) are currently 170bps versus senior unsecured credit spreads (5 year equiv) of 70bps and T1 credit spreads (5 year equiv) of 220bps. Historically, the T2 sub debt / senior unsecured credit spread multiple has been at 2x so anything over 2x is generally seen as a buy signal. For reference, this multiple is 2.4x as of 3/7/24.