Why Subordinated Tier 2 is our preferred sector in credit

Written by Head of Capital Markets & Fixed Income James Williams

Ever since the release of the Australian Prudential Regulation Authority’s (APRA) letter in early November 2022 regarding its expectations on capital calls, the market has had one eye on the pending call of the Westpac Banking Corp (WSTP) February 2023-28 line. 

With global credit spreads widening over the past 12 months, APRA’s letter reinforced existing prudential requirements for Additional Tier 1 (AT1) Capital or Tier 2 (T2) Capital, in an attempt to deter ‘uneconomic calls’ from being made. Its prudential standards require that issuers should not call AT1 or T2 capital and replace it with an instrument with a higher credit spread, as it may create the expectation that the issuer will exercise a call option on other outstanding AT1 and T2 capital instruments with call options.

In this Special report, we look at how the market has reacted to the recent WSTP call, the lack of recent Australian dollar denominated T2 supply, and why a new subordinated T2 deal should be well receivedby the market.

 All eyes on Westpac Banking Corp

Not only is WSTP the first major bank with a call date following the letter’s publication, but it also has the lowest coupon of any call in the next three years (BBSW +140 basis points (bps)). This means it has been seen by some as a test of APRA’s stance following the letter’s publication.

The call notice could be issued any time from 2 January 2023, so many had expected it to be called   in early January together with a new deal. By 27 January, investors became uneasy as there was no news on the call, and the momentum of tightening spreads started reversing.  On 27 January, the Australian Securities Exchange issued a notice that APRA had approved the call, thereby removing concerns around extension risk. This triggered a rally in spreads,  as well as a material re-steepening of the curve (e.g. WSTP June 2023-28 securities tightened 75bps).   The chart below shows the indicative T2 curve pre-letter, post-letter, and post-WSTP call. As at 2 February, the WSTP call has unwound roughly half of the curve steepening (e.g. the one to five-year part of the yield curve flattened from 107bps to 58bps and is now back to 80bps).  

Lack of Australian dollar denominated Tier 2 supply

Combined with the fact that Australian dollar denominated T2 spreads are now as tight as they were in May 2022, it is surprising there has been no primary supply in Australian dollars since October. There have, however, been three foreign currency denominated T2 deals in January, with National Australia Bank and Macquarie issuing 10-year US dollar bullets to avoid extension risk.

Since the WSTP call notice, ANZ has issued the first callable structure since the APRA letter—a EUR 1 billion 10 Non-Call 5, which was well received and raised over EUR 3.5 billion. This deal swapped back to BBSW +280bps (approximately 30-40bps tighter than where an Australian dollar-denominated 10 Non-Call 5 would be expected to print).  

At the start of January, existing Australian dollar fixed rate T2 debt was trading around 15bps tighter than equivalent floating rate note tranches. However, over the course of the month this contracted all the way back to flat. The contraction was likely driven by the large move in outright yields. The market’s pricing of the Reserve Bank of Australia’s terminal cash rate fell from 4% at the start of January to 3.6% following weak employment numbers on 19 January. Outright yields have retraced some of this move in recent days, so it will be interesting to see if this flows through to increased demand for fixed tranches. The Commonwealth Bank of Australia’s T2 deal in November was split almost 50/50 fixed/floating, while the three deals predating this were predominantly fixed rate.

While private banks have been buyers of T2 debt due to attractive outright yields, institutional investors have been selling T2 to make way for new supply. Based on data supplied to us by Westpac, in January, private banks bought almost five times more T2 than they sold, while institutional investors sold almost five times more than they bought. Westpac believes that institutional investors were likely ‘saving their bullets’ for anticipated primary supply in January which ultimately never eventuated. Private banks, on the other hand, have smaller but more regular interest that is spread out over time and better suited to buying in secondary markets rather than large blocks in primary markets.

How would a new deal be received?

The combination of higher outright yields (driven by nine consecutive rate rises from the Reserve Bank of Australia) and higher T2 spreads (driven by total loss-absorbing capital requirements) have led to yields of more than 6.00% in subordinated T2. For this reason, coupled with tightening spreads for BBB-rated corporates, we believe this sector will continue to attract investors searching for yield in the investment grade space. A new Australian dollar deal would be very well absorbed and may not have the new issue concession that many are hoping for. We are hoping to see new T2 supply in February, with a new issue from WSTP most anticipated, as it has been noticeably absent from the market. Based on today’s pricing, a new subordinated T210 Non-Call 5 issue for a major bank, such as WSTP, would come at a spread of BBSW +240bps area, a yield to call of 6.06% on a fixed rate coupon.

Estimated supply in 2023

Source: UBS

Latest pricing for domestic major bank T2 floating rates notes

Source: Westpac

Latest Pricing for domestic major bank T2 fixed rate debt

Source: Westpac

Latest pricing for regional banks and insurance companies' T2 floating rate notes

Source: Westpac

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