Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 54

Bank hybrid market undergoing significant change

An important change has hit the ASX listed bank hybrid market recently that we think may lead to a contraction of margins on listed hybrids for the remainder of the year.

Since the drafting of Basel III regulations in 2010, bank hybrid structures had been shunned by institutional investors who refused en masse to accept the so-called ‘non-viability’ clauses embedded in Basel III complying hybrid structures. The non-viability clause allows the regulator to convert the hybrid to equity to improve a bank’s solvency under crisis conditions. Such a clause has obvious risks, which retail investors either overlooked or ignored, while institutions thought it gave the issues too much ‘equity’ characteristic without sufficient return.

A flagship Tier 2 capital issue by Bendigo & Adelaide Bank in January 2014 saw institutional investors participate for the first time under the new bank capital regime. Westpac, ANZ and IAG have all issued into the wholesale over the counter (OTC) market to institutional investors since.

The institutional dislike of the 'non viability' clause relates to the absolute ability of APRA to exercise its option to convert capital instruments. To date, APRA has given no  guidance as to when it will exercise this ability and has told banks that “we will know a non viability scenario when we see it”. It’s not totally clear what the reasons are for the recent change of mind by institutional investors, and it may include the still attractive margins or fewer fears about the global banking system. It hasn’t been guidance from APRA about when it will use the 'non viability' clause.

We believe that the change in institutional investor sentiment has the potential to squeeze supply for the retail ASX listed market for the rest of 2014.

Maintenance of 3% margins since the implementation of Basel III

A few months ago, we thought the listed hybrid market would produce a total return this year close to 6% (including franking). However, due to the changed sentiment of institutional investors in the wholesale OTC market, there now appears potential for spread contraction and capital growth in prices in the listed hybrid market. Absent another equity market crisis or major event shock, we think that listed major bank issues are unlikely to attract a margin of greater than 3% again (the margin is paid above the bank bill rates, currently below 3%, and adjusted for franking).

The chart below shows margins on US corporate BBB and BB debt and the composite margin of ASX Listed Major Bank Hybrids. The zero cash rate in the US has driven investors into higher-yielding assets since the GFC and margins on BBB and BB corporate debt are close to 1996-2006 levels, half their late 2009 levels. However, margins on the ASX Listed Major Bank Hybrids are largely unchanged, having fluctuated around 3% for the past four to five years. They were recently higher than US BB corporate debt for the first time ever.

CD Snip1 210314

CD Snip1 210314

Data: Bloomberg, ASX and Elstree

Major bank hybrid margins have been relatively flat due to a massive amount of supply as banks began to comply with the much more restrictive Basel III capital regime. In absolute terms, the market size has doubled since late 2011. Prior to the GFC, the market used to absorb about $3 billion on an annual basis. The chart below shows gross and net (after allowing for redemptions of issues) since 2007. The net issuance amount is probably the best guide to supply/demand equations.

CD Snip2 210314Data: ASX and Elstree

The year 2012 was characterised by about four years of normal issuance while 2013 was about 3 years of normal issuance. Until recently, we expected that 2014 would produce about $8 billion in net issuance or $15 billion in gross issuance. The two bars for 2014 show two outcomes: the first assumes that banks refinance all their Tier 1 hybrids in the ASX market and the second adds another $6 billion of Tier 2 debt that banks need to finance. Financing $15 billion of gross issuance would mean that margins would remain high.

Institutional demand will impact directly on ASX listed issuance

The institutional acceptance of the ‘non viability’ clause in Basel III compliant transactions stems from a broad-based change in sentiment toward banks in general.

A recent issue in Europe by UBS for example was five times oversubscribed, and was issued at a record low margin. Australian banks could now issue Tier 2 capital instruments at margins well under the current trading margins of ASX listed hybrids. If the Australian bank issuers tap the international market and local institutional investors continue to follow their international contemporaries into the market then the level of net issuance in the ASX listed market could potentially fall to the level last experienced in 2006.

Unless there is a sudden reversal, institutional investors are now most likely to absorb the $6 billion of Tier 2 debt that the Australian banks need to issue this year. The chart below shows the proportion of hybrid issue ownership by the top 20 holders for each issue, grouped by years of issue. In recent years, the Top 20 (i.e institutional) investors have held as little as 20% or less of some issues, showing a high percentage of small retail investor participation, with around 40% of some issues owned by investors with less than $50,000 holdings. Investors will buy anything with the margins higher than 3% recently.

CD Snip3 210314Data: Elstree and ASX.

Retail and SMSF support

In 2011, bank term deposits were readily available at rates of 6% or higher. In 2012 they were still around 5%. Driven by the volatility of equity markets, SMSF holdings of cash, including term deposits, doubled from around $70 billion in 2007 to $150 billion in 2013.

As the cash rate is now down to 2.5% and term deposits of less than 12 months are prefixed with a ‘3’ the loss of purchasing power after adjusting for inflation is causing concern among retirees. Unlike their institutional brethren, retail investors have been comfortable since the implementation of Basel III with the major bank name hybrids, and were willing to overlook the complex regulatory clauses and risks in search of total returns in excess of 6%.

Although official statistics on SMSF investments are dated and too aggregated, there are signs in the 2013 statistics of an absolute fall in cash holdings, despite total SMSF funds increasing rapidly. There is a lag between new term deposit rates falling and cash flows, but any term deposits that were written in 2012 at rates of 5% or above will now be rolling at around 3.5%. We estimate that as little as a 2% reallocation by SMSF trustees from term deposits to hybrids will account for all the expected net new issuance in the listed hybrid market this calendar year.

If institutional demand in the OTC market soaks up the bank Tier 2 issuance, there will be a shortage of ASX listed hybrid supply at the time when a decent chunk of the $150 billion in SMSF monies invested in term deposits is looking for a new home.


Campbell Dawson is a Director of Elstree Investment Management Limited. Information and opinions contained in this article should not relied upon as authoritative and may be subject to change without notice.


Leave a Comment:



Bank limitations create opportunities for non-bank lenders

How 'ridiculous' are hybrids for retail investors?

Ian Macfarlane on emerging markets, banks and property prices


Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Latest Updates


The 'Contrast Principle' used by super fund test failures

Rather than compare results against APRA's benchmark, large super funds which failed the YFYS performance test are using another measure such as a CPI+ target, with more favourable results to show their members.


RBA switched rate priority on house prices versus jobs

RBA Governor, Philip Lowe, says that surging house prices are not as important as full employment, but a previous Governor, Glenn Stevens, had other priorities, putting the "elevated level of house prices" first.

Investment strategies

Disruptive innovation and the Tesla valuation debate

Two prominent fund managers with strongly opposing views and techniques. Cathie Wood thinks Tesla is going to US$3,000, Rob Arnott says it's already a bubble at US$750. They debate valuing growth and disruption.


4 key materials for batteries and 9 companies that will benefit

Four key materials are required for battery production as we head towards 30X the number of electric cars. It opens exciting opportunities for Australian companies as the country aims to become a regional hub.


Why valuation multiples fail in an exponential world

Estimating the value of a company based on a multiple of earnings is a common investment analysis technique, but it is often useless. Multiples do a poor job of valuing the best growth businesses, like Microsoft.


Five value chains driving the ‘transition winners’

The ability to adapt to change makes a company more likely to sustain today’s profitability. There are five value chains plus a focus on cashflow and asset growth that the 'transition winners' are adopting.


Halving super drawdowns helps wealthy retirees most

At the start of COVID, the Government allowed early access to super, but in a strange twist, others were permitted to leave money in tax-advantaged super for another year. It helped the wealthy and should not be repeated.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.