A new capital security issued on Tuesday night by Westpac Banking Corporation (Westpac) has highlighted the lack of higher-yielding opportunities available for New Zealand-based investors.
Banks fund the loans they make from deposits, bonds and shareholders’ contributions. In Australia, that’s also the order in which funds are repaid in the event of default. To go into further detail, there’s also a class of securities that sit between shareholders’ funds and senior bonds; securities in this class are issued with various features under a range of names but, broadly speaking, they fall under the umbrella of ‘additional capital’.
Last week, the Australian Prudential Regulation Authority (APRA) finalised an amended requirement that Australian banks raise an additional three percentage points of total capital. It is expected this increase will take the form of additional capital, or more specifically, Tier 2 capital, ie coupon-paying bonds that are subordinated to senior bonds.
The Reserve Bank of New Zealand’s (RBNZ) view of Tier 2 capital stands in stark contrast to APRA’s. Firstly, APRA requires Tier 2 securities to include a clause, known as a non-viability trigger, which requires that the securities are written off or converted into equity if APRA deems it appropriate. In order for New Zealand dollar securities to be consolidated onto the parent bank’s balance sheet and count towards group Tier 2 capital, APRA requires a non-viability trigger. The RBNZ is sceptical of non-viability triggers for several reasons, including its view that non-viability triggers may not be able to be implemented in a timely or practical manner to be able to save a bank from failure. The RBNZ has prohibited these securities as components of the regulatory capital stack. Therefore, any Tier 2 securities issued in NZ ultimately become very expensive funding when considered at a group level.
Secondly, in its most recent capital review, the RBNZ has questioned the need for Tier 2 entirely given it helps protect creditors in the event of default when the RBNZ’s primary goal has been to avoid default. The upshot is that NZ banks are unwilling to issue Tier 2 securities.
Source: RBNZ, APRA
Three years ago, prior to the RBNZ’s determination, there was $4.7bn of additional capital securities outstanding in the NZ market. As securities have matured and not been replaced, this value has dwindled to just $2.0bn[1]. That is making it difficult for kiwi investors to source higher-yielding investments. Even though this void has created an opportunity for corporates to issue subordinated debt on terms attractive to them, very few have taken advantage of this excess demand. In the Harbour Income Fund, as a result, we have instead been seeking opportunities in Australia.
It is estimated that the current stock of Australian Tier 2 securities will increase from A$40bn to A$90bn. That’s probably too much for the Australian market to absorb alone and is likely the reason Westpac issued in USD last Tuesday night. There were questions whether the expected increase in supply would push spreads wider. Judging by the reported ten times over-subscription for Westpac’s $1.5bn (two-maturity) deal, there remains plenty of appetite for this paper globally. The 15-year security swaps back to New Zealand at a spread of 2.4%, while the 20-year security lands at 2.6%.
While we retain a positive credit outlook on the Australian banks, this yield pick-up is yet to entice eligible Harbour Funds.
[1] $1.15bn of the maturities have been from foreign banks not impacted by the RBNZ’s ruling
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