Banks turn to covered bonds as funding spreads widen

Australian Financial Review 14 Jan 2019 7:10 PM

Jonathan Shapiro

Australia's big four banks have turned to ultra-safe covered bonds to meet their annual funding targets, as wholesale funding margins have increased to their highest level in two years.

On Friday, ANZ Banking Group completed a £750 million ($1.34 billion) AAA-rated covered bond issue, marking the first time the bank had turned to this form of funding in more than a year.

Covered bonds grant investors additional security because they are backed by a pool of mortgages. They rank ahead of senior bonds, followed by Tier II bonds, which carry additional risks because they can be "bailed-in" or converted to equity in a crisis. Tier II bonds however rank ahead of Tier I hybrids and ordinary shareholder equity, which are the most expensive forms of capital for banks to raise. As markets volatility has risen and funding markets have become more difficult and expensive to access, the big banks have resorted to covered bond sales to meet an estimated $100 billion annual wholesale funding task.

The ability to issue relatively inexpensive covered bonds, granted by regulators in 2011, has countered rising funding cost pressures and another round of demands to increase capital from regulators in Australia and New Zealand.

In November, the Australian Prudential Regulation Authority said the Australian banks may need to increase the amount of capital they hold by about $75 billion through the issue of Tier II "bail-in" bonds.

Meanwhile the Reserve Bank of New Zealand last month flagged a capital increase that could force the big four Australian banks to raise an additional $15 billion to $20 billion of Tier I capital on behalf of their subsidiaries, a move that analysts say could lower equity returns and dividend payouts.

"Capital intensity is increasing, dividend payout ratios are too high," Deutsche Bank analysts said.

Meanwhile the banks are set to push back on a proposal by APRA to meet global "too-big-to-fail" standards by lifting their Tier II "bail-in" capital levels from 2 per cent to as much as 7 per cent of risk-weighted assets.

While the banks are likely to argue that the market for Tier II bonds is no longer large enough to support between $67 billion and $83 billion of new issuance in this format over two years, bond investors say the move is positive for senior debt holders.

"If implemented as proposed, it's a credit-positive for senior bond holders as the capital buffer protecting senior bond holders increases," said Vivek Prabhu, head of fixed income at Perpetual Investments.

The expected increase in bail-in bond issuance also would reduce the amount of senior bonds the banks would be required to sell. "Technicals would also be positive for senior bond holders given senior issuance requirements would be reduced by the quantum of Tier II issuance, reducing supply of senior bonds," he said.

The banks are pushing for the regulators to allow them to issue senior non-preferred bonds or Tier III capital, to meet "bail-in" capital targets rather than lower ranking Tier II bonds, because there is a larger market for the former.

Andrew Papageorgiou of fixed-income fund Real Investment House said although global investors might prefer Tier III bonds over Tier II bonds, ultimately they were similar.

"When it really matters, you will see these spreads converge, as ultimately the default point is identical; the only difference comes in the form of modest subordination," he said.

While Tier II bonds sold by Australian banks in foreign markets have widened substantially in anticipation of the potential for increased supply, Mr Papageorgiou said Australian dollar-denominated Tier II bonds widened only modestly by comparison. "It can only mean that these spreads are not fairly reflective of the actual risk of crowding and oversupply here in Australia, or that there is no real concern."

While Westpac and ANZ chose to raise funds through the sale of covered bonds to international investors, last week Commonwealth Bank braved the local bond market with a five-year "senior" bond.

The bank raised $2.2 billion and paid a margin of 113 basis points over the bank rate, the highest spread paid by a major bank for five-year funding since mid-2016.

National Australia Bank's head of credit research, Michael Bush, said margins of five-year senior bank bonds from Australian banks had tended to trade between 70 and 115 basis points in the 10 years since the global financial crisis, aside from two market-disruptive events in 2012 and 2016 and the CBA bond issue had "very much tested the upper levels of that range".

"That notwithstanding, the recent positive tone evident within European credit markets, combined with the recent support in the Australian domestic market, suggests that range may hold for a while longer," said Mr Bush.

While credit markets have proved more volatile recently after two years of relative calm, the banks are fortunate their overall annual funding tasks are reducing as they have issued sufficient long-term bonds to meet global liquidity requirements while slowing credit growth is reducing their need for additional funds.

CBA for instance had a funding target of $25 billion this year, down from $33 billion and $40 billion in previous years.

ANZ did not issue any covered bonds last year because favourable markets allowed it to place lower ranking senior bonds with ease.

The bond issue was also noteworthy because it was the first time an Australian bank had issued a covered bond that referenced the Sonia – or Sterling Overnight Index Average – benchmark rate rather than the London Inter Bank Offer Rate.

Australian and international regulators have warned institutions to prepare to phase out the LIBOR which is the reference rate for trillions of dollars of debt-related securities. That is because banks, fearful of reputational risks following the global interest-rate rigging scandal, will no longer make the submissions required to calculate the rate.

ANZ paid a 68-basis-point margin above Sonia, converted to a rate of between 70 and 75 basis points over the bank bill swap rate, credit analysts estimated.