While last month’s market turmoil highlighted the potential downside for bank AT1s, it has also highlighted the strength of Australian bank T2s which sit at the top of the regulatory capital structure, offering higher risk adjusted returns. Phil Strano, Senior Portfolio Manager, Fixed Income, explains why.
In the month or so since the forced merger of Credit Suisse and UBS, and the subsequent full write downs of Credit Suisse’s AT1 securities, market volatility has settled. However, while $A major bank AT1 spreads have pushed out by ~50bps, they still appear very expensive compared to their USD and EUR denominated equivalents.
Moreover, $A AT1s are also expensive compared to their T2 counterpart, with ~50bps in additional spread (refer Chart 1) offering poor compensation for inferior credit quality and, no matter how implausible, the higher probability of impairment in a non-viability scenario. The more appropriate AT1 spread for the additional risk remains roughly twice that of T2, akin to where offshore AT1s currently trade.
Chart 1: Australian Major Bank Spreads – 4Yr T1/T2/Senior
In light of a number of questions from clients, it’s worth providing a reminder of exactly what happened to Credit Suisse debtholders. While the Credit Suisse AT1s were zeroed, their T2 securities were protected and rolled into the newly merged Credit Suisse/UBS entity at par. This distinction is incredibly important, since Australian major bank T2 securities sit at the top of a very large regulatory capital structure, protected from impairment by CET1 (~11-12%) and AT1 (~1.5-2%) capital (refer Chart 2).
Chart 2: Major Bank Regulatory Capital As % Of Risk Weighted Assets
It is also worth reminding that, from a capital perspective, T2s have been de-risked in recent years, with total Tier 1 capital (CET1 + AT1) increasing by ~4% since the GFC. When we include the ~1-2% of earnings buffers which can be redirected to capital replenishment, it is clear that T2 securities look insurmountably safe today from impairment, given they are protected by ~14.5-15.5% in subordinated capital and earnings.
With their current ~6.0% yields, Australian major bank T2 securities remain important overweights across all our diversified Australian credit portfolios. Not only are they contributing significantly to income levels, they are well placed to provide capital growth opportunities when spreads eventually contract from current high levels.
Finally, we see the latest volatility as having a silver lining for T2s, with call risk now significantly diminished from what the market speculated a mere six months ago. Investors will likely recall APRA stating its desire for financial institutions to consider not calling T2 securities due to credit spreads being wider than historical levels. Not calling T2 securities would generally extend their life for a further five years and lower valuations.
After the recent bank failures in the US and the Credit Suisse/UBS merger, the argument of whether APRA will or won’t permit T2 calls now seems somewhat redundant. This was further reinforced last week, with APRA approving yet another supposed ‘non-economic’ call for BOQ’s T2 securities which is likely to be replaced by a new T2, likely to be ~100bps more expensive.
In essence, not enabling T2 calls on mere higher spreads would risk far greater economic damage in the current environment and appears to be off the table even though, as we noted at the time, APRA’s initial argument held little merit
Yarra’s overweight positions in T2 underpin the attractive running yields on offer in the Yarra Enhanced Income Fund (5.9%) and Yarra Higher Income Fund (6.8%) from these high-quality, average investment grade portfolios.