Australian USD Discos – High Risk

• WBC, ANZ, and CBA have not called their outstanding USD discos and currently receive no regulatory capital benefit after the transition period ended from 1 January 2022
• The discos represent very low-cost funding for each respective bank
• Since COVID-19, customer deposit funding has increased significantly providing a reliable funding alternative
• The caveat to this argument is what happens regarding the eradication of US LIBOR as a reference rate
• The upside scenario results in a range of investment outcome(s) from a yield of 25-45% depending on whether they are called in Sept 2023 or Sept 2024
• From where the market is currently pricing these instruments, the downside scenario is not a doomsday one but would result in a further px decline to mid $50s
• Those with high-risk tolerances may be well served looking at the WBC and ANZ discos. Current pricing is in the $67-68 area – and if you believe the upside/downside scenarios are binary in nature, then the probabilistic return outcome would point towards having a small exposure.

Potential material capital gain on the investment if the discos are called following eradication of US LIBOR as a reference rate.

See range of investment outcome(s) from a yield of 25-45% depending on whether they are called in Sept 2023 or Sept 2024. Whilst LIBOR has no definite end-date, the expectation is for eradication as a reference rate in either 2023 or 2024. Then, a bank needs to ultimately determine if it uses this event as a catalyst to call these instruments or decides to restructure with a new floating rate benchmark.

The upside scenario is predicated on the banks (and APRA) deciding that investors are no longer holding a security which reflects the originally issued security. APRA has consistently pointed out that local banks need to replace instruments which do NOT meet their initial funding/capital guidelines. Furthermore, relying on BBSW (1m or 3m) as a fallback method for transition may not be seen as pro-active as calling these exposures when the rest of the world are moving towards a risk-free rate (RFR).

Upon eradication of US LIBOR as a reference rate, discos are restructured with a new floating rate benchmark (most likely 1m or 3m BBSW) and become a perpetual, floating rate, instrument. While this is a risk, the downside for investors has been somewhat priced in with the instruments px falling from $85 to $70 over the last six months.

These instruments would then be re-priced to reflect a margin somewhere between a banks’ near-term funding cost and the cost of perpetual debt (alongside an illiquidity cost). Let’s assume for purposes of illustration, that the cost of what would be regarded as “senior unsecured, perpetual paper” would be around 300bps. This accounts for 100bps (5yr senior unsecured funding) plus 200bps for the perpetual nature (alongside an illiquidity cost). From where the market is currently pricing these instruments, the downside scenario is not a doomsday one but would result in a further px decline to mid $50s.

1. Using 300bps as the cost of what would be regarded as “senior unsecured, perpetual paper” translates into a px of $53. Note assumed rate has been changed to 3m BBSW of 3.06% from US LIBOR of 4.23% to calculate the realisable px.

WBC and ANZ discos are marked at $70. CBA disco is marked at $85. As an indication, the WBC disco provides the following investment outcome(s) based on a call at $100 at the September coupon payment date. The banks have the option to call the notes on each coupon payment date but are not required to. We provide 2 examples, based on a Sept 2023 and Sept 2024 call.

1. 30 Sept 2023 – US LIBOR + 40.66% (yield of 44.90%)

2. 30 Sept 2024 – US LIBOR + 20.49% (yield of 24.73%)

The discos are floating rate securities that pay a coupon set against 6m US LIBOR plus a spread.

LIBOR had served as a globally accepted key benchmark interest rate for financial markets for more than 40 years. Published in five currencies and seven tenors, it comprised daily estimates of borrowing costs in the unsecured market provided by a panel of major banks. The issue was when liquidity in the borrowing market dried up during the GFC, LIBOR was no longer anchored in a robust underlying market. This made it unsuitable as a widely used reference rate.

Whilst LIBOR has a definite end-date, not all interest rate benchmarks that reflect bank funding costs or “IBORs” are expected to discontinue. For example, Australia’s local credit-benchmark BBSW (1m or 3m) could be used in the future?

The upside scenario is predicated on the banks (and APRA) deciding that investors are no longer holding a security which reflects the originally issued security. APRA has consistently pointed out that local banks need to replace instruments which do meet their initial funding/capital guidelines. Furthermore, relying on BBSW (1m or 3m) as a fallback method for transition may not be seen as pro-active as calling these exposures when the rest of the world are moving towards a risk-free rate (RFR).

Upon eradication of US LIBOR as a reference rate, discos are restructured with a new floating rate benchmark (most likely 1m or 3m BBSW) and become a perpetual, floating rate, instrument.