What credit spreads are telling us

Christopher Joye

Coolabah Capital

A few quick thoughts on recent credit spread movements in the Tier 2 subordinated bond and the Additional Tier 1 capital hybrid markets.

First, the screenshot below shows the clean price of the most recently issued, 5 year major bank subordinated Tier 2 bond. The impact of APRA’s November 2018 consultation paper on its draft Total Loss Absorbing Capacity (TLAC) policy is very clear, with the price suddenly falling off a cliff over the following week.

We had the credit spread on this security gapping wider from about 167 basis points (or 1.67%) above the 3 month bank bill swap rate (BBSW) immediately before the APRA report to as far as 220 basis points thereafter. The sudden lurch downwards in the value of the bond reflects the market pricing in the expectation that APRA will force the major banks to issue almost $100 billion of extra Tier 2 to satisfy its TLAC policy, which would more than triple the stock of these securities that are outstanding (ie, this would be an enormous supply shock).

The drift further downwards from November to mid December was attributable to the general credit spread weakness that was being experienced globally at the time.

What is more interesting is the noticeably steady recovery in the bond’s price since December. This security is now trading on a credit spread of about 175 basis points over BBSW (from the wides around 220 basis points) as the market has gradually adjusted its view and priced in the expectation that APRA will evolve its TLAC policy to allow the banks to fund the large TLAC shortfall using a lower cost and more liquid security known as a non-preferred senior, or Tier 3, bond. Global issuance of Tier 3 is about 10 times the size of Tier 2.

Another interesting market spread-wise is the major banks’ Additional Tier 1 capital hybrids listed on the ASX. The overarching story here has been that prior to the ALP’s 15 March 2018 announcement on its proposal to eliminate cash refunds on franking credits (which was subsequently diluted to exclude pensioners), five year major bank hybrid spreads were trading at about 300 basis points over BBSW in January 2018.*

Today they are around 365 basis points over BBSW, which is the de facto compensation you get for the (increasingly lower probability) risk that the ALP’s policy comes to pass. One fascinating development on this front has been the likelihood that even if the ALP wins the election, the Senate is committed to blocking the policy. Over the weekend the AFR reported:

“Labor's plan to scrap cash payments for excess franking credits looks increasingly likely to fail after the Centre Alliance appropriated the Coalition's slogan to use as its own mandate in the upcoming election. The party, which has two incumbent South Australian Senators and is set to hold the balance of power in the Senate, has adopted the slogan "Stop Labor's Retiree Tax" in a bid to have a third Senator, Skye Kakoschke-Moore, elected on May 18.”

As a direct result of the ALP policy, there has been a surge in fund managers raising extremely attractive "permanent capital" with high fees via new junk bond listed investment companies (LICs) on the ASX that actively market themselves as alternatives to hybrids for investors who think they will lose their cash refunds. 

Many of these junk bond products have lower credit ratings than hybrids (or no ratings at all), implying greater default risk, and significantly inferior liquidity (or no liquidity). Ironically, many are also paying significantly lower total returns net of fees than franked hybrids, even though they carry higher risk. Folks have clearly been advising unsophisticated retail investors to sell hybrids to buy these riskier products on the basis of what appears to be the potentially fallacious assumption that Labor’s franking policy will be legislated.

After rallying in March, ASX hybrid spreads have recently moved a little wider, with daily volume on the ASX elevated, as investors switch into the riskier junk bond LICs (see the right-hand-side of the chart below).

As Koda’s Paul Heath and Magellan’s Hamish Douglas argued last week, one concern is that these LICs are being sold by individuals profiting from large conflicted sales commissions of up to 2% to 3% of the value of the money they raise from mums and dads for the LICs. (In the case of normal unlisted managed funds and listed ETFs, conflicted sales commissions are banned under the Future of Financial Advice (FOFA) laws.)

When one of these LICs inevitably sours, and retail investors are forced to exit the product at huge discounts to its NAV because of the closed-end nature of the vehicle (it is extremely common for LICs to trade at large discounts when markets crash), it is quite possible that litigation funders will encourage retail investors to launch class action litigation seeking compensation for any potential mis-selling into products that have inferior liquidity and higher risk to those that they sold to buy them. We have already seen one LIC cost mums and dads hundreds of millions of dollars in losses---it is only a matter of time before we see more.

* Note: Not-for-profit super funds and charities can also continue to claim cash refunds on franking credits, and there are now retail super funds in the accumulation phase that are allowing retirees to in-specie transfer their hybrids into the fund and continue to get paid cash refunds for their franking credits, which are utilised by the majority of members who can offset their tax bills with them.

This information does not constitute, and should not be relied on as, financial or investment advice or recommendations (expressed or implied) and it should not be used as an invitation to take up any investments or investment services. The information has been prepared by Smarter Money Investments Pty Limited (ACN 153 555 867), which is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd that 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. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 40 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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