Fixed Income

As very active capital structure investors, we are constantly engaged in repricing the absolute and relative valuation levels spanning preferred equity, subordinated (or Tier 2) debt, non-preferred senior (or Tier 3) instruments, senior unsecured bonds, cash deposits, super senior covered bonds, and off-balance-sheet asset-backed securities (ABS and RMBS). It sounds complex---and it is!

Our assessment has been that a Coalition victory at the federal election, which our portfolio positioning anticipated, has important consequences for bank capital structures in particular. This view was firmly validated by the price action on Monday with major bank hybrids jumping more than 0.46% in price terms while the required credit risk premium on 5 year major bank hybrid securities compressed from 3.56% above the quarterly bank bill swap rate (BBSW) to 3.37% above BBSW (or 19 basis points of spread contraction) in just one session. 

Indeed, the jump in hybrid valuations on Monday was almost the exact opposite of the losses incurred on 14 March 2018 when Labor first announced its disastrous franking policy. The reaction in major bank hybrids was echoed in the junior ranking ordinary shares, which leaped 6% to 9% on the day with the normal beta, or correlation, between the two asset-classes. 

Enclosed below are our more specific thoughts on what the Coalition victory means right across bank capital structures that most investors are exposed to...

General comments on implications for Aussie bank credit

Unsurprisingly, the sleepy hollow that is the major banks’ over-the-counter cash bonds (credit) hardly reacted to the Coalition victory notwithstanding the stunning equity and hybrids price action on Monday.

(We had maintained the contrarian call that it would not be surprising if the Coalition won the election comfortably with a majority, and that market pricing, polling, and betting odds around this event were all totally wrong.)

It is very normal to see a lead-lag relationship between listed equity and OTC credit, and this appears to be once again in play.

While we think that the probabilities of an RBA rate cut in June should logically fall somewhat given the expectation of a much stronger housing recovery (as policies to remove negative gearing and increase CGT by 50% disappear), the central bank signalled that the jobless rate must drop materially to stave off a near-term cut.

So RBA rate cuts remain the base-case, and we would expect strong pass-through from the banks as funding costs have shrunk sharply (ie, at least 40-50bps of any 50bps cut).

One rider is APRA's important announcement today that it is going to remove the minimum 7% serviceability interest rate banks are required to apply when lending to borrowers. We predicted this would happen on April 29 (see here), and APRA has gone even further than we expected: removing the 7% rate altogether instead of dropping it by 0.50% and introducing a minimum 2.5% buffer over the lending rate. 

This at the margin buys the RBA more time, and reduces the probability of rate cuts (perhaps the RBA only does one as opposed to two cuts). 

It is also much more positive for the housing market than a pure 0.50% rate reduction. I currently pay 3.5% on my mortgage: APRA's new 2.5% buffer means my bank only now needs to apply a 6.0% interest rate assumption when figuring out how much it lends to me compared to a 7.25% rate previously (banks have added 0.25% to APRA's 7% minimum rate). So the binding borrowing constraint has dropped a huge 1.25%! We estimate that this could increase a borrower's maximum borrowing capacity by as much as 14% assuming they are paying a 3.5% discounted home loan rate.

In April we forecast that the housing correction would end if the RBA cuts. We project that APRA's rate cut combined with the market expectation of two RBA rate cuts will lift Aussie house prices by 5% to 10% in the 12 months after they are implemented.

As we previously explained, we think the RBA is, at the margin, comfortable with the idea of cutting the cash rate to 1.0% knowing that it can ramp-up Aussie quantitative easing (QE) by buying government bonds, senior bank bonds, and ABS/RMBS if it needs to.

Indeed, one significant insight that we have not disclosed before is that Aussie QE should–given the unique variable-rate (as opposed to fixed-rate) bias in our financial system–rationally involve the RBA buying bank senior bonds first and then, on a secondary basis, ABS/RMBS.

The transmission mechanism from bank senior bonds is going to be much more powerful than the conduit offered by ABS/RMBS given the latter are only a tiny share of the big banks’ funding sources. (Senior bank bonds and AAA rated ABS/RMBS are all already repo-eligible with the RBA.)

Any future RBA rate cuts will be a game-changer for everything. They should be very positive for lower risk assets paying attractive spreads above the cash rate (ie, senior, subordinated and hybrid bank credit) and of course, combined with APRA's massive cut, for the housing market.

We would not be surprised to see Standard & Poor’s analysts, led by Sharad Jain, consider an upgrade to Australia’s economic risk score in the same way they pre-emptively downgraded it before the housing correction in 2017 and upgraded the sovereign rating to AAA stable last year.

Combined with the additional circa NZ$15 billion of common equity capital required by the Reserve Bank of New Zealand, this would have the consequence of lifting most of the major banks’ S&P risk-adjusted capital (RAC) ratios to above the crucial 10% threshold, which would increase the major banks’ stand-alone credit profiles (SACPs) from “a-” currently to “a”.

This would in turn boost the credit ratings on the major banks’ (hypothetical) Tier 3 bonds from BBB+ to A-, Tier 2 bonds from BBB to BBB+, and Additional Tier 1 (AT1) capital hybrids from BB+ to BBB-. The latter move is significant, because it pushes hybrids back into the investment grade band.

Note also that the Coalition’s tax cuts are estimated by CBA economics to be worth another 1-2 RBA rate cuts, which combined with the current federal budget surplus (it is in surplus over the 12 months to March on all measures) means the domestic economic outlook is very positive. Overlay a near US$100 a tonne iron ore price, and life is looking pretty peachy right now subject to the US and China resolving their trade impasse.

Specific election impacts across bank capital structures

> Major bank senior bonds:

Credit positive because stronger economic growth and the housing recovery will power bank credit growth while RBA rate cuts will reduce bank arrears and losses, improving profitability and ameliorating tail risks.

Further, the current big bank tax on the major banks’ wholesale debts is not likely to be changed under the Coalition whereas this was a definite risk under Labor. Indeed, it is possible the Coalition could eventually remove the levy, especially in a second ScoMo term if the budget is seriously strong. (It was introduced as a budget repair measure.)

More generally, there will be less populist bank regulation that had been threatened by Labor with both ASIC and APRA less likely to engage in gratuitously punitive actions to satisfy their political masters.

The Commonwealth Treasury is also likely at the margin to be even more rational (it has been doing a brilliant job since the Financial System Inquiry in 2014) when it comes to financial system regulation under the Coalition.

All of this is happening while APRA forces the banks to build their CET1 ratios to above the “unquestionably strong” 10.5% target and the RBNZ demands they build even bigger 14.5% buffers, both of which are credit positive.

Finally, as noted above, major bank senior should be a key QE target if the RBA ever undertakes it.

> Major bank Tier 3 bonds:

As populist bank bashing pressures dissipate, the probability of APRA implementing a rational Total Loss Absorbing Capacity (TLAC) policy surely improves.

Our expectation of a contractual (with statutory linkages) Tier 3 solution is demonstrably the simplest for APRA to implement in liquidity, cost, capacity and regulatory change terms. A far less rational, more costly, and less liquid Tier 2 solution should, at the margin, become less likely.

> Major bank Tier 2 bonds:

Insofar as APRA has less pressure to sate the populist demands of politicians, and Tier 3 becomes more probable, the risk of an irrational Tier 2 supply shock falls, which is positive for this sector that was blown-up when the original draft TLAC consultation paper was released in November 2018. Market pricing currently expects APRA to embrace global best practice and a Tier 3 product.

> Major bank AT1 hybrids:

Immensely positive (as evidenced by the ASX price action on day one) given cash refunds on franking credits are no longer at risk of being wiped out.

Coming into the May federal election, 5 year major bank hybrid credit spreads were sitting at 3.56% above BBSW. In January 2018 prior to a surge in new issuance and the ALP’s announcement of the proposed franking changes, spreads were at 3.0% above BBSW. Back in mid 2014 they were trading at below 2.4% above BBSW.

As the chart below shows, while the major banks have been boosting their equity substantially--with CBA’s common equity tier 1 (CET1) ratio rising from 8.2% in June 2013 to 10.3% in June 2018, which is very positive for hybrids--the credit spreads offered on these securities have drifted wider, not tighter, in recent years.

Australian bank hybrids are automatically converted into ordinary shares if a bank’s CET1 ratio drops to 5.125%. As the banks have increased the equity buffer protecting hybrids against this risk by about 70% (or from a 3.1% CET1 buffer above the 5.125% conversion threshold in 2013 to a 5.2% buffer in 2019), one would expect the required credit spread to shrink, not increase.

This may explain why institutional investors are increasingly gravitating to the sector with the $60 billion Unisuper reported to have invested $300 million in the latest NAB hybrid in February 2019, and committed about $1 billion to major bank hybrids in 2016.

As banks continue to de-risk their business models by selling non-core operations and focussing on their core savings and loans activities, I see no reason why major bank hybrid spreads should not compress to levels observed in 2014 and earlier, which implies credit spreads of less than 3.0% above BBSW. This would drive substantial total return outperformance.

What the Coalition victory assures is that no political party is likely to ever mess with franking credits again. This means retirees should be able to comfortably claim their cash refunds on franking credits in perpetuity. Over time, this should see advisers and brokers who encouraged clients to sell hybrids over the last 14 months re-embrace the sector.

Disclaimer: This information has been prepared by Smarter Money Investments Pty Ltd. 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. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Past performance is not an indicator of nor assures any future returns or risks. Smarter Money Investments Pty Limited (ACN 153 555 867) is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd, which holds Australian Financial Services Licence No. 482238 and authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited that holds Australian Financial Services Licence No. 255016.



Comments

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Robert Delforce

If Mr Joye was so convinced the LNP price to win on betting sites was so comprehensively wrong then he would no longer HAVE a mortgage because he would put all he had/could muster on them to win at the $8 paid for LNP win on Saturday. Oh the genius of after-the-event statements by so-called experts like Mr Joye.. Sorry Christopher: a economist-logic tragic have a good old Aussie jibe, here!!