Why Unisuper cornerstoned cheap NAB hybrid paying 6% pa

Christopher Joye

Coolabah Capital

In my column today I analyse the new NAB hybrid, which was cheap and attracted a monster circa $200m bid from the $70bn goliath Unisuper with CIO John Pearce choosing to fade the ALP election risks and associated franking debate, and possibly to capitalise on a change in the way Aussie banks report their capital ratios, which could significantly reduce hybrid risk premia (click on that link to read or AFR subs can click here). Excerpt enclosed:

Investors should probably be thanking Pearce for helping secure an unusual 4-handle. Unisuper’s trade would not likely have been a one-off, and was probably enmeshed in a suite of "relationship" transactions knowing Drew Bradford’s outstanding markets team, which has the best debt and equity capital professionals in the game. These include the likes of John Bennett, Nick Chaplin and the David Gonski of capital structures, and a mysterious individual known as “Noddy”.  

A final driver of the price might have been that NAB wanted to print more volume because of its looming Tier 2 bond maturities that may not be able to be refinanced. Since APRA’s 2018 consultation paper on the need for banks to build extra loss-absorbing capacity, the primary market for Tier 2 has been effectively closed. NAB notably has a EUR750 million Tier 2 maturity in November followed by a $1.1 billion refinancing task in March 2020.

Global primary markets for Tier 2 have become increasingly illiquid as it has been supplanted by a higher ranking, and better rated, security known as Tier 3 (or “non-preferred senior”). In Europe leading banks like BNP have struggled to close even modest Tier 2 transactions.

Since the Additional Tier 1 (AT1) capital sourced via hybrids is fungible with Tier 2 for the purposes of a bank’s Total Capital, a slightly larger issue via NABPF will reduce the amount of Tier 2 it has to replace over the next 12 months. Interestingly, Westpac treasurer Curt Zuber has just called his $1 billion March Tier 2 maturity, which he may not have to replace given he is carrying excess AT1.

As part of the new NABPF hybrid issue, NAB is prudently seeking to place an extra $750 million of “Common Equity Tier 1” (CET1) capital to institutional investors, which will boost its pro-forma CET1 ratio to above APRA’s “unquestionably strong” 10.5 per cent target according to JP Morgan.

The annual cost of NABPF is 0.8 per cent higher than the security it is replacing (NABPA), and the dearest (for the issuer) major bank hybrid since mid 2016. This will further increase NAB’s funding costs, which is one reason why it recently lifted mortgage rates.

Return on equity pressures will only intensify following the Reserve Bank of New Zealand’s decision to require the majors to increase their CET1 buffers across the ditch by a chunky $14 billion. That is awful news for shareholders chasing outright returns, but a positive outcome for bank creditors.

This week news broke that one of Europe’s largest banks, Santander, decided not to repay a EUR1.5 billion hybrid on the first of its quarterly call dates, which had an unsurprisingly muted effect. In fact, the value of Aussie bank hybrids in US dollars actually rose following the news as credit spreads compressed. This is because it is common for European banks not to call their hybrids and Tier 2 bonds if it does not suit them.

It is also why we generally refuse to invest in European banks, which are plagued by immensely capricious, and frequently non-rational, regulatory and political environments. Life is simpler sticking to predictable Antipodean deposit-takers and their well-capitalised US brethren. The local regulator, APRA, is among the most highly regarded globally for its rational decision-making processes and multi-decade track-record of avoiding catastrophic blow-ups.

One important prospective change for hybrid investors that APRA has recently canvassed is the harmonisation of the banks’ capital ratios to a globally comparable reporting standard. Aussie banks publish superficially skinny capital ratios that need to be adjusted to make them consistent with offshore banks. While on a harmonised basis our banks look like rock-stars, these numbers are only available via the banks themselves and treated with scepticism overseas.

If APRA does move to harmonised ratios, the cost of issuing hybrids could fall. APRA and the banks are currently at a competitive disadvantage globally because the triggers at which point Aussie hybrids are converted into shares are set at a CET1 ratio of 5.125 per cent, which is measured using APRA’s internationally low CET1 numbers.

If APRA shifts to comparable CET1 metrics and keeps the hybrid triggers at 5.125 per cent, as is the case with over 70 per cent of global banks, it would give both the banks and APRA much more time to mitigate periods of capital erosion, and by doing so avoid highly destabilising automatic bail-in events. (APRA always retains the free option to bail-in via its non-viability clause.)

Current Aussie bank CET1 ratios are around 10.5 per cent on an APRA basis—the distance between this number and the 5.125 per cent conversion trigger defines how much time APRA has to avoid bail-in.

If the banks’ CET1 ratios were harmonised globally, they would jump to around 16 per cent, doubling the de facto distance to default, which should in theory reduce the required risk premia on Aussie hybrids.

A final interesting feature of Unisuper’s bid is that it signals Pearce is not plussed about the prospect of Labor coming to power and removing the ability of non-taxpayers to claim cash refunds on their franking credits. This is because Unisuper can, like 90 per cent of all other investors, continue to harness franking credits to ameliorate its tax liabilities. It is also probably a function of the fact that Unisuper is being compensated for this risk given that spreads on five year major bank hybrid are 0.60 per cent wider than they were prior to Labor’s announcement on March 15. The latter news precipitated waves of selling from investors between March and May as a near-certain Labor victory was priced in.

The ability of the major banks to comfortably raise over $5 billion of hybrid capital since November suggests that the franking dramas have been ephemeral, as we expected. And it would not be surprising if the measures were watered down significantly by the many independents opposed to them in the senate.

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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