Retail investors have proven their affection for bank issued hybrid securities. And why not? They have historically paid a stable income, greater-than-term-deposit rates and with less variability than bank dividends. However, with the bank regulator, APRA, reviewing whether hybrid securities are fit for purposes, there is risk retail investors will be prohibited from investing directly in hybrids. With an announcement on this matter expected shortly, we look at a likely income generating alternative. Namely, Residential Mortgage-Backed Securities or RMBS.
Bank Capital: Back to basics
A bank’s capital is the “cornerstone of its financial strength. It provides the financial resources to enable a bank to withstand periods of stress, and protects depositors in the event the entity needs to be resolved” (APRA). There are three types of regulatory capital, which I touch on below, but with specific reference to AT1.
Within the capital hierarchy of banks, AT1 ranks in between common equity (or ‘CET1’) and subordinated debt (or ‘Tier 2’). CET1 is the most subordinated layer of capital in a bank’s capital stack, and well-known by retail investors via the equity market. CET1 is permanent capital, with no legal maturity and management has full discretion on whether dividends are paid or not. It is intended CET1 be immediately available to absorb bank losses as and when they occur. CET1 or common equity is both a retail and wholesale market.
Tier 2 capital is debt in form, with a legal maturity date and there is no discretion around payment of distributions (coupons), they are contractual obligations. Failure to pay would trigger default of the issuing bank. Tier 2 is intended to be available during resolution of a bank, that is when it is at the ‘point of non-viability’. Under such circumstances, CET1 and AT1 capital is assumed to have been burned through, or written off because of losses. Tier 2 is used to facilitate recapitalization of the bank to allow it to continue operating as a going concern. The Tier 2 market is an over-the-counter market, which lends itself to being a wholesale market only. Minimum parcel size of $500,000 also making it prohibitive to retail investors.
AT1 capital ranks between CET1 and Tier 2. While it has no legal maturity date, giving it some semblance of permanency, it does have a call date – typically 5 – 7 years after issuance. AT1 distributions are discretionary, meaning payment can be missed with no legal ramifications. AT1 is traded on the ASX and has proven popular with retail investors, which is at the core of APRA’s concerns. AT1 is designed to absorb losses as part of early crisis intervention to restore a bank’s capital position, and can be used as part of resolution if needed.
Credit Suisse situation and subsequent APRA review…
For reasons I won’t go into here, Credit Suisse – a global systemically bank – was on the cusp of collapsing in the early months of 2023. To prevent failure, and to avoid potential contagion risks (remember Lehman Brothers), the Swiss banking regulator arranged a shot-gun marriage with cross-town rival, UBS, who was coerced down the aisle, acquiring Credit Suisse for $3.5bn. When the dust settled, Credit Suisse’s AT1 bondholders had been wiped out, their securities worth zero. Strangely, Credit Shareholders remained whole, violating the ‘absolute priority rule’ touched on above.
In light of these events, and given more than half of AT1 paper in Australia is in the hand of smaller, retail investors, APRA launched a review to determine whether AT1 capital remained fit for purpose. APRA is concerned banks may be reluctant to cancel AT1 distributions to conserve capital given the market signaling effect and contagion risk. Further complicating things, Australian banks rely more on AT1 (relative) than international peers (~14.0% of tier 1 capital vs 11.6% - 12.4% globally), likely because it is a cheap form of Tier 1 capital.
APRA has flagged three potential options to ensure AT1 remains fit for purpose.
One is to improve the design of key features to ensure AT1 does what it’s supposed to do – minimal impact on retail investors.
The next is to reduce the reliance of AT1 for regulatory capital purposes – potentially reduces issuance and availability of AT1 securities.
And last, and this has most potential impact on retail investors, is to restrict their access to AT1 securities, which is what we’ve seen in US and UK markets in the past.
APRA requested market feedback by 15 November, 2023. Six months on, there has been no formal announcement, but we would assume we’re approaching some resolution. With the risk that retail investors will be prohibited from investing in AT1 going forward, what’s an alternative with similar risk-return dynamics? Read on…
Alternatives...
AT1’s are tradable on the ASX, so they provide some perception of liquidity (daily traded volumes are actually quite small as a % of total outstanding), and they have historically provided investors with an enhanced income stream relative to say term deposits. They have also provided less capital volatility than bank equity, although they are not completely devoid of risk in this regard. During COVID AT1 securities fell as much as 20% vs bank stocks that fell 35%. For comparison, Tier 2 securities fell perhaps 3% around the same time. Like Tier 2 securities, AT1 securities pay a floating rate distribution, which is determined by a fixed margin (set at issuance) over the bank bill swap rate, which is reset every 90 days. Unlike Tier 2 securities, the distribution on AT1 securities is discretionary.
If we look at the underlying fundamental risks of AT1, an alternative is Residential Mortgage-Backed Securities (RMBS), specifically the mezzanine tranches. Roughly speaking, 70% - 80% of bank lending assets are residential mortgages vs 100% for RMBS structures. Like bank capital stacks, RMBS have different tranches or layers of risk, from the first loss equity piece all the way up to the AAA rated tranche. Put a bank capital stack next to an RMBS structure, and the similarities are clear. One could say that a bank is just one big RMBS. The AAA tranche of an RMBS is akin to bank deposits, while the AA tranche is akin to senior debt and so on. Continuing the analogy, the BB tranche is akin to AT1.
However there are significant differences. RMBS is a secured investment, backed by a pool of mortgages. Hybrids on the other hand are unsecured. Further, RMBS begin to amortise 18-24 months post issuance, which effectively reduces risk for investors. RMBS are generally shorter dated, with weighted averages lives of around 3.5 years vs 5 – 7 years for AT1. Where AT1 out-trumps RMBS, at least optically and for now, is access and liquidity. Retail investors can invest themselves in AT1 via the ASX and can trade in and out as they please. RMBS on the other hand is the domain of wholesale investors, such as Mutual Limited. To gain access to RMBS, a retail investor would need to choose a fund that invests in RMBS, such as the Mutual Credit and Mutual High Yield Funds.
A comparison of RMBS vs AT1 is tabled below. The most like for like comparison is the ‘BB’ RMBS tranche vs the AT1. The average coupon on the BB tranche is around BBSW+550 bps, but has been lower and has been higher, but this is the average. Given prevailing BBSW rates, this provides a coupon of 9.80%. Compare this to the last AT1 deal, from ANZ, the distribution on this security is 7.51%. The table also compares capital price volatility, which in this instance is the standard deviation of daily price movement, from which we see RMBS has been marginally less volatile than AT1. One point to highlight also, the RMBS market is over $150bn in size, whereas the AT1 market is less than $50bn.
Investors might raise housing market risk as a reason for avoiding RMBS over AT1, but we’d point out if there was in fact a marked sell off in house prices, which precipitate credit loss issues, AT1 securities are more exposed than RMBS. Lastly, we would point out that no rated RMBS tranche in Australia has ever defaulted. Even through the Global Financial Crisis, the RMBS market held firm.
