Australian Basel III-bonds come of age

Author: Ashley Lee | Published: 27 Mar 2014
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Australia’s Basel III-compliant bond market is among the most sophisticated globally. And while a framework has been established for Additional Tier 1 (AT1) offerings, more innovation is expected in Tier 2s.

The Australian market has developed independently of other developed jurisdictions. Contingent convertibles (CoCos) are exciting in Europe, non-existent in Asia, but fairly common in Australia. Most deals in the country include equity conversion instead of a write-down at the point of non-viability (PONV).

The Australian Prudential Regulatory Authority (Apra) was one of the first regulators to implement Basel III. Australian financial institutions began selling Basel III-compliant bonds in 2012, and those early deals created a template that has been replicated by subsequent offerings.

"It’s very well established what is needed for a security to be Basel III-compliant," said Shannon Finch, partner at King & Wood Mallesons.

Equity conversion

Convertibility has been a common feature of hybrids in Australia. The only new aspect surrounding the equity conversion in Australia was the mandatory nature of the non-viability trigger and the introduction of mandatory conversion into Tier 2 instruments, said Patrick Lowden, partner at Herbert Smith Freehills.

Market participants fought for the conversion into equity feature when Apra was determining its Basel III rules.

An immediate complete write-down without attempting conversion didn’t strike the right balance with consumer protection and the securities’ position in the priority chain; they started as either preference shares or deeply subordinated notes. The idea that they would be treated less favourably than ordinary equity in a non-viability situation seemed incongruous, said Finch.

"The conversion into ordinary shares brokered a compromise between shoring up the financial system and protecting investor interests, she added."

Partial write-down or conversion has been a feature of most – if not all – offerings since Apra published the full Basel III prudential requirements, said Lowden. A partial write-down is possible in a general non-viability situation when that’s adequate for the institution to remain viable, but isn’t possible in the context of a public sector injection.

To protect investors, Apra has mandated an equity conversion price floor set by reference to the market price of the shares when the notes were originally issued. "There used to be a 50% floor, but that’s been dropped to 20% following the implementation of Basel III," Lowden said. 

Key takeaways

  • Australia’s Basel III-compliant bond market has developed quickly;
  • Non-viability clauses in Australia usually allow equity conversion instead of a complete write-down at the point of non-viability. Partial write-downs or conversions are also permitted;
  • There is an established framework for Additional Tier 1 bonds, innovation dominates in Tier 2s. More Tier 2 offerings to institutional investors are expected.

What’s next

"We expect Tier 1 offerings to remain reasonably consistent," said Finch, noting that the repeat issuance process has been smooth and non-viability terms have been much easier to resolve.

She added that while the initial focus was AT1, the market has recently seen an increased focus on Tier 2 bonds, including some offerings with cross-border elements in their structures.

This month ANZ sold an $800 million Tier 2 bond, marking its first Tier 2 deal and the first time an Australian bank sold Basel III-compliant notes in US dollars.

More Tier 2s are expected, as institutional investors become more comfortable with non-viability clauses. Bendigo and Adelaide Bank opened the wholesale market in February, selling A$300 million ($264 million) in ten-year non-call five Tier 2 notes in the first Australian deal marketed solely to institutional investors. Fund managers bought 60% of the notes, demonstrating demand from more sophisticated investors.

Others quickly followed, with Westpac selling A$1 billion ($926 million) in Tier 2 notes to the wholesale market in March. Insurance Australia Group (IAG) also completed an A$350 million Tier 2 offering to the institutional investor market – the first Australian insurance company in the Tier 2 market.

Related links

How Australia hybrid clarifies Basel III implementation

Australia’s first Basel III-compliant Tier 2 hybrid explained

Asia’s Basel III Tier 2 bond evolution continues

CoCos’ stars have finally aligned