The Australian bank regulator, APRA, is proposing to phase out Alternative Tier 1 capital (‘AT1’ or ‘Hybrid’) securities for local banks. As existing AT1 paper reaches its call date, the last being in 2032, banks will be required to replace it with Tier 2 capital. By 2032 bank AT1 securities will cease to exist, which leaves a bit of a hole in retail investors investment universe. In this piece I discuss a couple of viable alternative asset classes to AT1, and a couple of our funds that invest in this space.
AT1 securities were an attractive investment for retail investors because of their higher yield vs perceived risk. They generated higher income than term deposits, and generally were less volatile than ordinary equity, and provided a more stable and predictable income stream than dividends. At the height of the covid related market panic major bank AT1 prices fell 20% on average, while major bank shares fell 40% - 50%). Bank bonds on the other hand, both senior and Tier 2, fell only 2% - 3%.
Per the announcement last week (LINK), APRA has determined that AT1 capital is no longer fit for purpose. In time, as the capital layer is phased out, retail investors will need to find an alternative. Looking at the income and capital characteristics of AT1 securities, two alternatives come to mind. Firstly, Tier 2 securities issued by the banks – which will replace AT1, and then secondly Residential Mortgage-Backed Securities (‘RMBS’), which I’ll touch on in turn below. Both are generally restricted to wholesale investors, so retail investors would need to look at a fund to gain exposure. Two of our funds, the Mutual Credit Fund (‘MCF’) and the Mutual High Yield Fund (‘MHYF’) both hold these securities.
Tier 2 capital, or subordinated debt as it is also known, currently ranks senior to AT1 in a bank’s capital stack. Apart from ranking, the main difference is that Tier 2 is a debt instrument, whereas AT1 is a hybrid, with equity characteristics. Tier 2 coupons are contractual, they can’t be deferred, such would be an event of default. AT1 distributions are deferrable without triggering a default. Tier 2 paper is often issued with a ten-year maturity, but with a five-year call option, which to date has always been met by Australian banks. Returns have been historically lower than AT1, but also less volatile as Tier 2 holders benefit from the buffer provided by the AT1. As AT1 is phased out, Tier 2 will effectively assume the ‘buffer’ role of AT1 and as such should be priced accordingly – higher yielding all other things being equal. This re-pricing will likely be a gradual process rather than rapid given the length of the transition period.
The schematic below details a simplified bank balance sheet. Liabilities represent the various sources banks use to fund their lending activities, or their assets. Further, to the right we have prevailing spreads for each layer of funding. This is the margin above the bank bill swap rate (‘BBSW’) that determines the coupon paid on these securities. The levels listed here ignore the pricing action seen in recent days as the AT1 spread has tightened as investors scramble to buy what they can before they are phased out.
The other alternative is Residential Backed-Mortgage Securities, or RMBS, specifically the mezzanine traches of these structures. In a simplistic sense, a bank’s balance sheet resembles one big RMBS structure. The bank’s assets are loans, predominantly first ranked mortgages, and the funding used to lend against these houses consists of deposits, senior bonds, subordinated bonds, and AT1. The interest on the mortgages is used to pay the interest on the funding sources, with the margin reflecting profitability, which is paid out to equity holders as dividends. For RMBS, the asset side is the same, first mortgages, while on the funding or liability side we have RMBS tranches rated as high as ‘AAA’ (deposit like risk) down to mezzanine tranches rated ‘BBB’ ‘BB’ or ‘B’ (AT1 like risk). As with banks, the interest income from the left side pays the interest expense on the right side. The balance goes to equity – although there are some structural features that prevent dividends being paid to the mortgage originators (banks) until RMBS holders are paid.
The schematic below should look similar to the simplified bank balance sheet above. In the bank example, should mortgages begin to fail in sufficient scale, equity and AT1 capital is designed to absorb losses (i.e. a capital loss for holders). Similarly, in an RMBS structure, the same situation would see the equity tranche absorb losses, and then the ‘B’ rate tranche, the ‘BB’ rate tranche and so on.
The A$ RMBS market dwarfs both the AT1 market (~$33bn) and the Tier 2 market (~$20bn) in outstanding securities at around ~$200bn. Rated tranches of RMBS structures attract higher spreads compared to equally rated ‘vanilla’ bonds. For example, an ‘AA’ rated RMBS is pricing around BBSW+175 bps, with a maturity of around 3.5 years, compared to say major bank senior paper (‘AA-‘) around BBSW+70 bps. Further down the stack, ‘BBB’ RMBS is at BBSW+200 bps vs BBSW+140 – 150 bps for equally rated vanilla bonds. The extra premium available on RMBS is compensation for perceived complexity risk and liquidity risk, although both are moderating as the market matures.
Now, how do retail investors invest? Both are restricted to wholesale investors, so the best way is through a fund, managed by a team of handsome and highly skilled investment professionals with over 100 years of collective experience. And here’s one I prepared earlier. Mutual Limited was established in 2010 and manages $3.5bn across four retail funds and over a dozen wholesale mandates. The firm has a prudent investment philosophy, focusing on bank paper and RMBS / ABS. I’ve personally been investing in RMBS since 1999.
Two of our funds are active in the RMBS / ABS space, with a summary of each fund below:
The Mutual Credit Fund launched in early 2020, more than doubling in size since launch. The fund invests in senior and subordinated (Tier 2) bonds issued by APRA regulated entities, so banks and insurers, with minimum holding of 60% (currently 70%). The fund can also hold up to 30% in RMBS or ABS securities, with a current holding of 22.2%. The fund is required to be at least 80% invested in investment grade rated paper (currently 90%). MCF returned 8.75% net over the past 12 months.
The Mutual High Yield Fund was established over 5 years ago. The fund has a heavy focus on RMBS / ABS assets, a growth market which has been driven by banks withdrawing from select lending markets, with the void filled by non-bank lenders. The RMBS / ABS market is their prime source of funding. RMBS / ABS allocations are at 42%, down on target of levels of 65% - 75% because the fund has enjoyed strong inflows that are still in the process of being deployed. MHYF returned +11.60% net over the past 12 months.
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