Last week Suncorp came to the market with a Basel III compliant ASX-listed sub debt deal (see Paul Rickard’s analysis of that issue here [1]), but investors need to be aware of the key differences between this new structure and those that came before, as the changes are significant. There are three key differences between “new-style” and “old-style” subordinated debt and investors need to be aware of the differences :
1. Step-up clause
New Basel III rules explicitly prevent the use of step-up margins on any new regulatory capital instrument, such as subordinated debt or Tier 1 hybrids. Step-up clauses were seen to be “incentives to call” by the Basel Committee and have been outlawed. “Old-style” step-up securities issued have been given grandfathering relief to still count towards the capital calculations, however only until the first call date, after that date their contribution to capital immediately falls to zero.
The existence of a step-up clause is an important differentiation in a subordinated debt (or Tier 1 hybrid) security; a step-up provides a strong incentive for the issuer to call at first opportunity. No such incentive exists for “new-style” subordinated debt.
2. Expectation of call
One of the key thrusts of the new Basel III capital rules is to remove any indication to the market that a capital security is intended to be called at the first opportunity. Rather, regulators want issuers to make each call decision on the economic merits of cost versus benefit (i.e. is it cheaper to call and re-issue another similar security and if not, the issuer should not exercise their call option).
By removing “incentives to redeem” from the structure of newly issued capital securities, the issuers are being forced by regulators to apply an economic rationale to the call decision. Further, investors will no longer be able to rely on reputation for expectation of call at first opportunity, something that appears to be lost on ASX investors.
It is anticipated that once the “old-style” securities no longer exist in the market, the long held expectation of call at first opportunity will change. The expectation of call at first opportunity is much stronger for “old-style” step-up securities than the “new-style” securities.
3. Non-viability clause
Any new subordinated debt (or Tier 1 hybrid) security issued after 1 January 2013 by an APRA regulated entity must include a “non-viability clause”. This is another of the sweeping changes under Basel III and states that if the regulator believes an issuer is at the point of “non-viability”, then they can require that any capital securities, with the requisite terms in the documentation, be written off (the default position) or converted to equity. This is a material increase in risk for “new-style” subordinated debt in particular, and worthy of further assessment.
Firstly, the point of “non-viability” is not defined. In layman’s terms, it is when the regulator deems the issuer to be sailing too close to the wind but that may be on capital grounds or liquidity or even due to a high balance of non-performing loans.
Secondly, it is only new issues. This means that in the event it is triggered, new issues, such as the Suncorp ASX-listed subordinated bond, could be converted to equity, where “old-style” subordinated debt and even Tier 1 hybrid issues that do not have such a clause could not be converted. This would effectively make the “old-style” securities senior in ranking.
Finally, the existence of these additional risks and, in particular, the difficulty in assessing the subjective “point of non-viability” greatly reduces the attractiveness to the wholesale (or over the counter) bond market. As such, there is limited institutional buying interest. A cynical view would be to suggest that the retail listed market is the preferred home for such “new-style” securities, as retail investors are less aware of the differences in risk and rather simply concentrate on comparative returns to other bank products, such as term deposits.
Conclusion
My preference remains for the “old-style” subordinated debt and particularly Tier 1 hybrid securities on a risk-reward basis. This is due to two key factors: (1) greater clarity on call/chance of call at first opportunity and (2) the fact the “old-style” securities do not have non-viability clauses.
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