Record AUD Tier 2 Supply
This quarter has been the largest quarter ever for AUD Tier 2 supply at over A$8bn. This provides investors many opportunities in the secondary market to pick up these recently issued lines, particularly as it is expected that primary domestic AUD tier 2 supply will be slower in the coming months. There are a couple of reasons for this. Firstly, many of the local banks and insurers are well ahead of their Tier 2 funding tasks and have limited refinancing upcoming – IAG is the only non-major with a call date due in 2024. Another reason we’d highlight is that offshore markets are looking as attractive as they have for a long time with USD Tier 2 currently pricing inside AUD.
Factors Driving Supply Dynamics
We continue to see strong value in bank Tier 2 subordinated notes, which rank above shares and Additional Tier 1 Capital but below senior debt and are yielding north of 5.5%. Notably last week S&P upgraded a range of Australian banks following a re-appraisal of industry risk. The rationale for the upgrade was “continued strengthening of regulatory and governance standards in the Australian banking sector has reduced industrywide risks. Simplified business models and advances in risk management have also contributed to this improvement.” Australia’s ‘Banking Industry Credit Risk Assessment’ (BICRA) score has improved from 3 to 2, which means Australia’s banking system is now ranked equal with Canada, Hong Kong, and Singapore, among others. BICRA scores range from 1 to 10, with 1 being the lowest and 10 being the highest (although there are no banking groups at level 1). For comparison, US, UK, and Japan are all rated 3 while Bolivia, Nigeria and Ukraine are rated 10. This upgrade flowed through to the stand-alone credit profiles (SACP’s) of the banks. Regional and mutual banks were upgraded across both senior and subordinated, while the majors and Macquarie were upgraded at the subordinated level. Spread impact was almost immediate, with major bank subordinated paper up to 5 bps tighter on average. The Kangaroo tier 2s joined in on the major banks and was 3-4bps tighter including the recent HSBC 10nc5.
Regular readers of IAM’s Market Insights will recall one of our high-conviction trade ideas last year being the USD Macquarie 6.125% AT1 which many of our clients picked up when it was yielding north of 9% [Macquarie AT1 issue – Income Asset Management]. Following the S&P update last week, it has now been upgraded one notch to BBB-, which puts it into investment grade.
Strengthening Australian Banking Sector
The strength of the Australian banking sector was reiterated by a recent speech by APRA Chair John Lonsdale at the AFR Banking Summit. On 26th March APRA released the speech titled “Severe but plausible: Taking a wider view of risk”. The main highlight was details around APRA’s ADI stress testing. This stress test was the first exercise to test the resilience of banks under APRA’s new bank capital framework that came into effect last January. APRA stressed banks under the following scenario: inflation peaking at +8.6% YoY (actual peak this cycle was +7.8% YoY), the cash rate increased to combat inflation, GDP fell -4.0% YoY, unemployment hit 10%, and house prices fell -35% over three years, and global funding markets temporarily shut down. All banks incurred a three-notch downgrade from the rating agencies. Overall, the results were encouraging and 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% and significant credit losses were incurred, with profits and dividends falling significantly.
Importantly, no interest payments on bonds or refinancing needs were missed, but dividends were heavily curtailed. Therefore, the results of the stress test indicated the resilience of the Aus banking system in the face of a major economic shock.
Full speech available here: APRA publishes Chair John Lonsdale’s speech to AFR Banking Summit | APRA
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