Coming tsunami of bail-in-able debt

Christopher Joye

Coolabah Capital

This week I outline our analysis of the coming tsunami of "bail-in-able" Tier 2 bonds care of APRA's finalised Total Loss Absorbing Capacity (TLAC) policy, which the big banks have only a small probability of successfully satisfying over the next 4.5 years if markets are anything other than picture perfect (click on that link to read the full column). 

In fact, it is probably in the banks' best interests to actively try to fail in this fund-raising task and compel APRA to embrace the statutory "Tier 3" bond solution that it has said it will explore as an alternative over the next four years. At the very least, the major bank treasurers, including Terry Winder, Curt Zuber, and Adrian Went, deserve to be among the best paid bank treasury executives in the world given the mission-impossible style task APRA has presented to them. 

By "bail-in-able" bonds, we mean a security that APRA can unilaterally convert into bank equity, or write-off completely. In its announcement this week, APRA made it curiously clear that it would do so "well before" a bank was at risk of insolvency, bizarrely placing Tier 2 in the position of going-concern equity capital rather than gone concern debt, as it had been widely assumed to be previously. 

It is a remarkably imprudent policy for a regulator that is admired around the world for its outstanding financial risk management (many would qualify that statement by highlighting that APRA's non-financial prudential supervision has been found wanting). Combined with the hilarious claim that APRA relied on RBA research that allegedly concludes there is no relationship between Tier 2 bond spreads and the volume of securities issued (that is, the demand for and supply of Tier 2 does not impact its price), the sheer naivety (and that is the kindest adjective I can find) of APRA's decision-making process beggars belief. Over the medium term, I think this policy is going to have highly deleterious consequences for APRA's reputational capital.

In my own portfolios we had taken profits on most of our (very small) Tier 2 bond holdings over the last six months in anticipation of a TLAC tsunami of some kind (ie, Tier 3 or Tier 2), preferring instead to move right up the capital structure to the safety and security of the major banks' near-riskless senior bonds, which have been the biggest winners from APRA's new policy. 

Following the release of the policy this week, S&P upgraded the major banks' senior bonds from AA- negative to AA- stable, as we had long predicted. And as the market has come to understand that the TLAC policy will disappear about ~$60bn of senior paper, dramatically increasing the subordination protecting senior bond holders, and radically reducing the need for the banks to issue 5-year senior paper (given the Tsunami of Tier 2 that they will be issuing instead will be very long dated indeed), we have seen senior bond spreads scream in towards post-GFC tights around 68bps for a 5-year tenor security. Only in January this stuff was trading around 115bps. 

One thing that is very clear to us is that the market has not yet figured out how much Tier 2 is actually coming. Brokers and investors appear to have deluded themselves that it will be a "manageable" deluge of only around $11bn to $13bn pa. This is totally incorrect. A conservative best-case scenario, which is in line with CBA's official projections, is $18bn to $19bn pa for the next 4.5yrs, and once you account for other non-major banks caught up by APRA's TLAC policy, and roll-overs of insurer and other smaller bank Tier 2, the real number is probably going to be around $20bn pa. That will heroically require a circa 37% increase in the global supply of Tier 2, which will be impossible if markets deteriorate along the lines of what we witnessed in 2011, 2012, 2015, 2016 or 2018. In a bad year, the banks will struggle to raise much more than $5bn to $10bn of Tier 2, which will only massively increase the issuance requirement in the following year to completely untenable proportions. (I can just hear the bank treasurers groaning as they think through this.)

This may explain why the most recent 5-year major bank Tier 2 deal, from NAB, is only trading 5 basis points wider than its pre-APRA levels (although other, shorter-dated, major bank securities, like Westpac's 2018 deal, are still up to 15 basis points wider, which makes absolutely no sense). 

The head of credit strategy at one of the major banks published a note following APRA's announcement stating that he expects the first 5-year deals to come at 250bps to 300bps over, implying that spreads have to move 60bps to 110bps wider than current levels. 

I reckon the first deals will come much tighter (say 225bps), but then the torrent of supply will gradually push spreads out over time. If there is the slightest scent of a risk-off move, spreads could very quickly gap wider, as we have seen in years past. I also expect the primary issuance to consistently reprice secondary curves, over and over again, until they move out to at least 250bps.

This is a tremendous opportunity for active and nimble investors that are expert at pricing bank credit and complex capital structure securities. An excerpt from my column is enclosed:

There isn’t a bank treasurer out there who thinks this is remotely possible if markets sour. The one Hail Mary everyone is clinging to is the hope the currently liquid and benign market environment persists in perpetuity. If the banks fail, they can justifiably blame the regulator, which has proposed a highly imprudent policy.

This is nevertheless manna from heaven for the sell-side debt teams that get to charge capital raising fees based on the complexity of the issuance. It’s also amazingly positive news for the major banks’ senior bondholders, who on Tuesday were rewarded with a crucial credit rating upgrade to AA- “stable” from Standard & Poor’s (as we had long predicted)...

Since late 2018 we had argued that there was not a snowball’s chance in hell APRA would force the banks to issue $125 billion of Tier 2 to satisfy its TLAC policy. That was the short-fall deriving from the draft policy published in November 2018 if you assumed reasonable balance-sheet growth and took the mid-point of APRA’s TLAC funding target, which was 4 to 5 per cent of risk-weighted assets (RWA).

In the final policy published this week APRA conceded its capacity assumptions were totally wrong, junking the 4 to 5 per cent target for a more reasonable 3 per cent goal and extending the timetable by one year.

It’s actually more complex than that because APRA has said it would like to one day get to its 4 to 5 per cent RWA threshold, but it accepts it cannot get there with Tier 2 (as we had argued). Instead, it will explore the feasibility of other Tier 3 funding instruments that we had previously canvassed here.

One thing that is clear is investors have not yet got their heads around the Tier 2 funding task. The majors currently have $34 billion of Tier 2, $19.2 billion of which has to be replaced by January 2024 when they have to be in compliance with the TLAC policy. APRA’s much lower 3 per cent RWA target equates to $50 billion of Tier 2 in current balance-sheet terms. That means total Tier 2 issuance of $69.2 billion between now and 2024.

While the majors have historically grown their balance-sheets by 5 to 6 per cent annually, we assume only 3 to 4 per cent growth (even though it could pick-up care of recent rate cuts). That increases the $69.2 billion of Tier 2 funding to between $81.8 billion to $86.4 billion, or up to $19 billion each year. (And much more if, heaven forbid, credit growth accelerates.)

Yet APRA has also said its TLAC policy will apply to other larger banks, which presumably means Macquarie, Bendigo, and Bank of Queensland (ignoring AMP and Suncorp for the time being). Suppose APRA only slaps these banks with half the majors’ TLAC target (or 1.5 per cent of RWA). With modest balance-sheet growth, this generates another $5.5 billion of Tier 2, increasing the total short-fall to as high as $91 billion (or up to $20 billion annually). And that does not account for the Tier 2 that has to be issued by smaller banks and insurers to refinance their existing debts.

Last year we argued that for APRA to hit its 4 to 5 per cent RWA target, it would have to embrace best practice globally and allow the banks to fund their TLAC requirements with a cheaper and more liquid instrument known as a Tier 3, or non-preferred senior (NPS), bond.

In 2018 there was $500 billion of Tier 3/NPS issued globally, almost 10 times as much as the volume of Tier 2 at a fraction its cost.

Tier 3/NPS is much cheaper than Tier 2 because it is classified as “senior”, not “subordinated”, carries a higher credit rating, and ranks above Tier 2 in the capital structure.

There are two forms of Tier 3/NPS: those with “contractual” bail-in clauses and, more commonly, a “statutory” alternative that can be bailed into equity under legislation.

Australian Tier 2 bonds are unusual because they are contractual, and have never been tested with a bail-in event nor challenged in the courts.

APRA curiously rejected contractual Tier 3/NPS for all the reasons that make our contractual Tier 2 flawed (ie, it is unproven and open to legal contest), but indicated it would examine the feasibility of statutory Tier 3/NPS over the next four years.

If the banks fail to raise $19 billion of Tier 2 each year, which I reckon is 75 per cent likely, APRA will be forced to accept other options.

The $90 billion question is what price the majors will have to pay to source all this Tier 2. NAB recently issued $1 billion of Tier 2 at a spread of 215 basis points above the bank bill swap rate in a market that was both buoyant and which assumed APRA would adopt a cheaper Tier 3 solution. (Investors were not anticipating a Tier 2 tsunami.)

In difficult years like 2015 and 2016 the majors have had to price small volumes of Tier 2 at 270 and 310 basis points above bank bills. Indeed, last year CBA’s Euro Tier 2 bond traded as wide as 330 basis points above bank bills.

APRA cites unpublished RBA research that finds no relationship between the supply of Tier 2 bonds and their price. But there is not a trader or treasurer on the planet who believes that preposterous claim. Given inherently finite demand for subordinated and equity-converting Tier 2 debt, the volume banks issue will have a huge impact on its price.

Even the head of credit strategy at one of the major banks wrote on Wednesday that the market heuristic that Tier 2 should trade at a fixed multiple to senior bond spreads is now “irrelevant”. That’s because senior bonds are all but riskless whereas APRA made it clear for the first time this week that it will treat Tier 2 bonds like “going concern” capital that can be bailed into equity “well before the is at risk of becoming insolvent”. (Offshore Tier 2 bonds are treated as “gone concern” capital that are only at risk of bail-in once a bank has failed.)

The second reason traditional Tier 2 to senior ratios are useless is because investors have to price a never-before-seen surge in Tier 2 supply. Whereas current five year major bank Tier 2 bonds are trading at just 185 basis points above bank bills, the major bank strategist says he expects to see new five year deals price at 250 to 300 basis points over bank bills “as a starting point”. Doubtless we will at some point see some very cheap Tier 2 that is worth picking up.

Read the full column here.

Disclaimer: This information has been prepared by Smarter Money Investments Pty Ltd (ACN 153 555 867), which is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd (AFSL 4822380 and an authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited (AFSL 255016). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. Past performance is not an indicator of nor assures any future returns or risks.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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