January 2025
By Freddie Stewart
After an eventful 2024, the new year has begun with new issuance in banking tier 2 credit from ANZ and Credit Agricole, both of which were met with strong demand. A key driver for the continuing demand from investors for tier 2 capital is speculation on the direction of the Australian cash rate being downwards over the course of 2025, but there are also other factors affecting credit spreads and their compression in recent months.
Bloomberg maintains reporting for key indexes in the Australian market; these are the AusBond Composite Index and the AusBond Credit FRN index and both of these are seen as key benchmarks for fixed income fund performance, depending on the fund objective of course. In early December, Bloomberg requested consultation on these indices for the inclusion of AUD non-viability trigger securities which includes Tier 1 capital – or hybrids – and Tier 2 bonds. Note this doesn’t include non-AUD non-viability trigger securities which remain an off-benchmark security for the key indexes above.
We see this as material news given APRA’s recent decision to phase out Tier 1 capital for Australian banks. Moreover, APRA has guided that they seek to do so by having larger internationally active Aussie banks replace their 1.5% of total risk weighted asset requirement of tier 1 capital with 1.25% of tier 2 capital alongside an additional 0.25% of CET1 capital.
Naturally, this decision has resulted in a compression in tier 2 credit spreads which for 5-year callable major bank paper sits at ~145bps at time of writing. This is a trend that we expect to see continue gaining momentum as hybrid issuance begins to tail off. However, should this consultation by Bloomberg result in tier 2 capital being included in both the AusBond Composite and AusBond Credit FRN indices, then there would be an amplified downward pressure on tier 2 credit spreads as allocators pour capital into the market with their mandated limits on tier 2 credit now a thing of the past. In theory, lower credit spreads on existing tier 2 securities held by investors equals higher capital price and outperformance for investors should this eventuate.
For investors sitting on cash and looking for a strong risk adjusted return, A- rated investment grade tier 2 capital from the major banks should be considered as part of the overall portfolio. With fixed and floating outright yields from 5.5% to 6%+ in the current environment, coupled with potential outperformance on fixed tier 2 if rate cuts do in fact eventuate, at IAM we are advocates for investors allocating to this part of the market as new issuance arises.
Please contact your IAM representative if you have any questions or would like to discuss.
