Post the global banking turmoil of 2023 (Credit Suisse and SVB), Australia’s Prudential Regulation Authority (APRA) has been reviewing the effectiveness of bank Additional Tier 1 (AT1) capital – commonly referred to as hybrids – in times of stress. On 9 December 2024, post a consultation process with stakeholders, APRA confirmed its decision to simplify the framework, phase out bank AT1 capital and replace it with other forms of more reliable capital i.e., Tier 2 Capital and Common Equity Tier 1 (CET1). APRA has acknowledged this is a drastic decision for the ~$40 billion bank hybrid market and it will support an orderly transition period. In this piece, we will be exploring the implications for the change, some frequently asked questions and posing alternative investment considerations for investors.
APRA has taken the view, in the wake of the Credit Suisse crisis, that AT1 capital (hybrids) would be ineffective in such times of stress.
APRA’s regulatory objective for AT1 was for CET1 and AT1 capital to act as buffers in stress and resolution scenarios, in order to allow a bank to continue to operate as a going concern. However, APRA has taken the view, in the wake of the Credit Suisse crisis, that AT1 capital would be ineffective in such times of stress.
International experience has shown that AT1 capital operates more closely to ‘gone concern’ capital, only absorbing losses at a very late stage of a stress event, where a bank is close to the point of failure:
APRA is phasing out the ~$40 billion bank hybrid market by 2032.
APRA is phasing out the ~$40 billion bank hybrid market by 2032. Changes to the composition of capital are expected to come into effect on 1 January 2027. Under the new framework, any AT1s (hybrids) outstanding would be treated as Tier 2 capital but will still remain subordinate to Tier 2 until their first scheduled call date. APRA is focused on an orderly transition and this approach will allow for a staged transition to the new framework.
APRA expects banks with surplus AT1 capital up to 1 January 2027 to not issue AT1 hybrids. This means banks may be able to issue AT1 hybrids as long as the new issuance does not have call dates beyond 1 January 2032 and does not increase the bank’s existing dollar amount of AT1 capital.
APRA has proposed to replace large banks’ requirement of 1.5% AT1 (hybrid) capital with 0.25% additional CET1 and 1.25% additional Tier 2 buffers.
APRA has proposed to replace large banks’ requirement of 1.5% AT1 capital with 0.25% additional CET1 and 1.25% additional Tier 2 buffers. This will impact 5 banks (CBA, Westpac, ANZ, NAB and Macquarie). Note that APRA will further consider the implications of the removal of AT1 on non-operating holding companies (NOHCs) that issue AT1 capital and will engage with impacted entitles.
Smaller banks, such as regionals, would replace their entire AT1 capital with Tier 2.
This would maintain the banks’ total capital requirements and would only change composition; hence it would not impact the banks’ overall credit soundness.
For the major banks:
Tier 2 bonds are subordinated debt designed to absorb losses and protect depositors and senior credits.
In order to meet Basel III and APRA’s TLAC (Total Loss Absorbing Capital) requirements, banks have been prolific issuers of Tier 2 bonds over the last few years. Australian major banks have issued over $100 billion in Tier 2 bonds in all currencies since 2013.
Tier 2 bonds are subordinated debt designed to absorb losses and protect depositors and senior creditors, forming part of each bank’s regulatory capital base. They are higher risk compared to senior debt but are more senior to AT1 hybrid holders and equity shareholders. This means that Tier 2 bonds are a cost effective form of capital for banks issue without diluting their equity holders. As the buyers of Tier 2 bonds are typically institutional investors, banks can execute transactions quickly in the over-the-counter (OTC) market within 24 hours. Tier 2 bonds can be issued with floating rate and/or fixed rate tranches, making these an attractive fixed income investment for investors looking to manage duration. Over the past two years, these investments have been in high demand by investors looking to lock in higher yielding fixed rate bonds following the 2022-2023 global central bank rate hiking cycle.
Australian banks are among the higher-rated global banks and have consistently maintained high credit ratings from the ratings agencies. This makes Australian major bank Tier 2 bonds attractive to global investors and are currently rated A- by the ratings agencies. Tier 2 bonds are higher quality than AT1 hybrids as coupons are mandatory. Unlike AT1 hybrids, Tier 2 bonds do not have franking (which can contribute to a modestly lower effective yield) and the final maturity must be a minimum of 10 years. The call date must be a maximum of 5 years before the maturity date. These bonds have call dates in order to provide issuers with flexibility to manage their capital efficiently.
As Tier 2 bonds are typically purchased by institutional investors in the OTC market, investors will need to be wary of the minimum parcel sizes for each bond. For Austraclear settlement, the minimum parcel is currently $500,000 notional. If Euroclear settlement is available, parcel sizes can be smaller but are subject to the minimum marketable parcel of the bond. LGT Crestone clients may purchase these bonds directly in the OTC market or via institutional bond funds and ETFs.
Tier 2 bonds are higher quality than AT1 hybrids as coupons are mandatory.
The 1.25% increase in Tier 2 requirements is not expected to have a material impact on the market or issuance requirements. This additional amount represents about a 20% increase in the size of the Tier 2 market by 2032. An estimated $24 billion of Tier 2 capital will need to be issued over 2027 to 2032 (about $4 billion per annum, $1 billion per bank) in order to meet the requirements. As the banks are already at APRA’s 2026 targets, issuance was expected to decrease from 2025 onwards to about $10-15 billion per annum. We see Tier 2 issuance now rising back to $15-20 billion per annum, in line with historical Tier 2 issuance levels since 2019. The increase in Tier 2 is likely to be gradual and banks would also be able to issue in all offshore markets in various currencies which will help to relieve supply concerns in the domestic market.
The 1.25% increase in Tier 2 requirements is not expected to have a material impact on the market or issuance requirements.
The S&P released a note stating the proposed changes could weaken the going-concern bank capital under its rating framework. Without offsetting action, this may lead to lower ratings on Tier 2 instruments issued by the major banks.
S&P only counts CET1 and AT1 as capital while calculating its ‘Risk Adjusted Capital (RAC)’ ratio. For large banks (major banks and Macquarie) there would be downgrades to T2 ratings only if banks' forecasted RAC falls below 10%:
Bloomberg is currently consulting with the market regarding a proposal to add bonds with non-viability triggers into the Ausbond Composite Index. This would mean that a number of Tier 2 bonds could be eligible to be added (approximately 38 out of a current total of 159 AUD Tier 2 bonds). The inclusion of Tier 2 bonds should be a technical positive for Tier 2 pricing, as it would likely support new demand from indexed funds, especially if existing bonds as well as future issuance are eligible. Insurance subordinated instruments without coupon deferability should also benefit from the changes.
Most Tier 2 securities have been issued in a 10NC5 structure (10 years to maturity, non-call period of 5 years). The fact that Tier 2 is the main form of regulatory capital for banks going forward may mean that APRA will scrutinise the approval process for calling the Tier 2 bonds and the risk of not being able to call the bonds on the first call date may increase.
APRA has noted that it will monitor developments in Tier 2 instruments and markets. Additional amendments to Tier 2 may be considered in the future including the potential to create layers of subordination and tranches in Tier 2 capital. However, APRA intends to retain simplicity in the framework and to not create new forms of capital. It is important to remember that Tier 2 only absorbs losses in resolution and when the bank is a ‘gone concern’. This means APRA will need to be clear about what it means by “point of non-viability” for banks.
Remaining in AT1 hybrids is very much dependent on individual clients’ needs for floating rate structures with franking credits issued by major and regional banks.
AT1 hybrids have been an anomaly in the fixed income market. Investors have been compensated for holding the hybrids until the first call date and then participating in the next reinvestment offer. With OTC bonds, if a bond is called, the investor receives their principal back and is exposed to reinvestment risk if they hold until maturity (or the call date). Without hybrids, investors will need to be more active with managing their fixed income portfolio.
Historically, many hybrids have traded above par in the months leading up to the reinvestment offer. This is on the expectation that a refinancing trade will occur, and investors will benefit from rolling into the new hybrid after receiving a full allocation. In the absence of this, if the market expects a bond will be called, the bond will trade closer to par as it approaches the first call date. Investors are no longer compensated for holding the hybrid until the first call date. Instead, investors will need to be active in the year or two leading up to the first call and look to switch into alternative bonds or opportunities.
Remaining in AT1 hybrids is very much dependent on individual clients’ needs for floating rate structures with franking credits issued by major and regional banks. AT1 hybrids cannot be called earlier than their first call option date so can remain in a portfolio returning income. However, as the call date approaches, clients will be required to look for an alternative investment and we would recommend not waiting for the call notice to avoid re-investment risk and opportunity costs.
Pricing on the ASX will remain but we do expect volumes and liquidity to reduce. The capital price will accrete towards par as the call date gets closer but should still offer a better return than Tier 2 due to the higher risks and structure associated with AT1 hybrids (and access to franking credits). The coupons are non-deferrable, subject to the dividend stopper and AT1 hybrids can be written down or converted into equity in times of financial distress.
Insurers and other non-bank financials are not impacted by these APRA changes and can continue to issue AT1 hybrids. However, the issue sizes for these issuers have historically been much smaller than the major banks and do not form a material part of the hybrid market.
Investors will need to be active in the year or two leading up to the first call and look to switch into alternative bonds or opportunities.
AT1 hybrids have been a popular source of fixed income exposure for investors since the days of the National Income Securities (NABHA) in the 1990s and the Basel III-compliant bank AT1 securities from 2013. Hybrid investors have benefited higher yielding franked distributions compared to more traditional forms of fixed income. However, without bank hybrids, investors will need assess the risk/return of other asset classes and fixed income opportunities.
LGT Crestone recommends switching into other investment grade credit opportunities such as Tier 2 bonds, corporates and kangaroo issuers. Depending on the risk appetite of the client, LGT Crestone also has several recommended higher yielding private debt fixed income funds targeting RBA Cash plus 3% to 4% which may be used to help increase the return of the portfolio to compensate for the lower risk/lower return investment grade credit and Subordinated Tier 2 sector. These funds invest in private debt which is unrated, and investors should discuss with their Investment Adviser whether they are suitable for their portfolio and individual needs.
LGT Crestone recommends switching into other investment grade credit opportunities such as Tier 2 bonds, corporates and kangaroo issuers.
AT1 hybrid credit spreads have tightened significantly since the initial APRA announcement in September 2024 and are now at their historically tightest level.
Investors should be active and switch into new issuance transactions as they arise.
The recent outperformance of AT1 hybrids has been driven by the withdrawal of future supply, however, the risks associated with this sector remain. Therefore, we are recommending that investors should take profit and switch into Tier 2 and investment grade credit, noting on a risk-adjusted basis, Tier 2 and senior unsecured is better value on a historical basis. Investors will notice a drop in income due to lower coupon margins as these instruments are less risky than hybrids. As an example, ANZ recently issued a 10NC5 Tier 2 bond transaction at BBSW+152bps. As of 6 February 2025, a number of the shorter dated hybrids are trading at levels below +180bps, with upcoming calls expected for ANZ Capital Notes 5 (AN3PH) and CBA Perls X Capital Notes (CBAPG). Investors can take profits by switching into the new ANZ issue.
Overall, while it may be disappointing for investors to see the bank hybrid market being phased out, we see this as an opportunity for investors to be more active with their fixed income portfolio and take advantage of new bond issuance and credit opportunities over the next few years.
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