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Shifting SandS in auStralia’S largeSt credit Sector

PartICIPantSn Mark Abrahams Head of Debt Syndicate NATIONAL AUSTRALIA BANK n Jason Bounassif Head of Markets AMP GROUP n Joanna Bushby Australia Treasurer BANK OF AMERICA MERRILL LYNCH n Richard Coyne Senior Manager, Group Funding NATIONAL AUSTRALIA BANK n Melissa Gribble Head of Frequent Issuer Coverage NATIONAL AUSTRALIA BANK n Mihkel Kase Fund Manager, Fixed Income SCHRODER ASSET MANAGEMENT n Tim van Klaveren Head of Credit UBS GLOBAL ASSET MANAGEMENT n Tim Ledingham Treasurer BANK OF QUEENSLAND n Philip Miall Head of Investment Grade Credit QUEENSLAND INVESTMENT CORPORATION n Helen Pericleous Senior Portfolio Manager, Credit Markets AMP CAPITAL n Simon Roubicek Director, Institutional Sales NATIONAL AUSTRALIA BANK n James Shaw Head of Funding BANK OF QUEENSLAND n John Sorrell Head of Credit TYNDALL INVESTMENT MANAGEMENT n Michael Witts Treasurer ING BANK AUSTRALIA

Moderatorn Laurence Davison Managing Editor KANGANEWS

inancial institution (FI) issuance has always been, and remains, by far

the largest sector of Australia’s credit bond market – despite banks’

drive to minimise their reliance on wholesale funding and the rise of

non-financial corporate issuance. In August 2013, National Australia Bank

(NAB) and KangaNews gathered key issuers and investors to discuss the state

of play in and prospects for the FI sector.

F

WHOLESALE VERSUS DEPOSIT FUNDING

davison in general, banks’ wholesale funding tasks have eased substantially since the financial crisis in response to regulatory demands around stable funding profiles. will structurally reduced wholesale funding programmes prove to be a cyclical feature of the market or should it be expected to persist over the long term?

n CoYne There has been a significant amount of regulatory change that has affected the way banks manage their balance sheets. The focus has shifted away from wholesale funding to retail deposit taking, while also reducing the reliance on short-term funding.

Within the Australian market, there has been a significant amount of competition for retail deposits. The system itself has been growing quite well to support the sector’s increased needs. Going forward we expect this to continue and we don’t see the focus on strong balance sheets dissipating.

“Although it is possible to do a smaller covered bond transaction, economically it doesn’t make sense. If it gets to a point where we think we could offer a decent-sized deal it might work, but currently it doesn’t add up.”J a S o n b o u n a S S I f a m p g r o u p

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davison we are starting to see some of the major banks acknowledge in results announcements that they are paying a notable premium for deposits relative to the cost of wholesale issuance. How much growth do bank funders think might be left in the deposit system, and at what point does the marginal value of adding to the deposit base stop being worth what you have to pay for it?n CoYne The transition to Basel III has a number of key dates we need to meet. In this context there is no real advantage in us pushing the envelope in terms of trying to grow our deposit share too quickly. It is a measured process and with deposit growth continuing at around 10 per cent, coupled

with low credit growth, we will likely transition towards these key dates naturally.

When you look at the pools of funds that we’d like to access more, Australia has a massive superannuation pool which is currently overweight equities compared with other global savings pools. A reallocation towards fixed income via self-managed super funds, for example, would be a net positive.

roubicek the margins being paid on term deposits (tds) have been pretty solid relative to other asset classes. what will happen when we start to see other asset classes looking attractive relative to tds, especially with regard to the margins that banks need to pay to retail for those tds?

“If the currency drops, the economics would become relatively less attractive than they have been. But if we are attracting and broadening our investor base we would in most cases still press ahead with a transaction.”J o a n n a b u S h b Y b a n k o F a m e r i c a m e r r i l l l y n c H

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n daVISon Is there a sense that Australian domestic appetite for a wider range of financial institution (FI) names – including from offshore – is both substantial and sustainable?

PerICleouS In terms of positioning funds, there is an element of our view around Australian macro which will determine our concentration into domestic banks and their capital instruments versus offshore banks – from the US and Europe – and will also

determine our investment into Australian dollars, US dollars and euros.

abrahaMS Overall, our perspective is that domestic appetite has been steady. It is the offshore element which really drives growth of a deal.

n daVISon Are Australian investors more comfortable with US and, especially, European FI names in the current environment?

Sorrell There is a lot of variation between different

Global borrowers returnThe Australian dollar market’s receptiveness to issuance by international banks has allowed for occasional deal flurries in recent years. While global banks have also eased their call on wholesale markets, AUD investors are willing to look at solid deals in their jurisdiction.

“PrImAry IssuAnce hAs Been Affected By the deleverAgIng of BAnks In the us, And of course In euroPe there hAsn’t Been much PrImAry Around. so we Are selectIvely BuyIng In secondAry.”P h I l I P M I a l l Q u e e n s l a n d i n v e s t m e n t c o r p o r a t i o n

markets. We have spent a long time looking at Europe. We do so as there are many different jurisdictions, so for Europe it is case by case. In North America we have been buying some FI names.

It also comes down to a question of pricing and understanding regulatory risk. For instance, we buy Asian issues. But we also look at things like how much of any deal is being sold back into Asia – and, therefore, how much could land back in the domestic market one day.

MIall Asian private banks, in particular, are an interesting group of investors that we need to understand. Investors need to be informed about the technicals, not only in the secondary market but even primary – to understand where and how deals have been placed.

Sorrell Another niche market – the covered bond market in Canada – gives us exposures we couldn’t otherwise get. It is a case of how well we understand the issuers, and again it is always going to be a requirement to apply a focused approach and understand these names not just by geography but on a case-by-case basis.

Mandate constraints on these issuers are not yet relevant because they have not issued in sufficiently significant size to take us near our limits.

n CoYne There has been significant volatility over the last five years or so and it will be some time before we see a return to where we have come from. Deposit trends are secular in nature and this risk is not a material concern to us in the short run.

Having said this, it is important to maintain a diversified funding profile. This means retaining access to as many different markets as possible – be they wholesale or retail – in order to fill any gap if it emerges.n WIttS We have seen the savings ratio go to 10-11 per cent from 6-7 per cent, and it has stayed there for three or four years now. If you look at household balance sheets, the value of their assets still has a fair way to recover. People are willing to give up some of their speculative returns for certain returns. n ledInGhaM From our perspective, there has been slower credit growth and savings ratios seem to have returned to historic levels. All the banks have benefited from the structural change that has come about through stronger deposit growth and being able to restructure the way balance sheets are funded.

At Bank of Queensland (BoQ) we have moved towards higher proportions of retail funding. Currently our deposit-to-loan ratio is around 66-68 per cent, so the majority of

our lending is being funded by retail deposits. BoQ targets a balanced approach between retail and wholesale funding, including creating diversity of funding through our wholesale base. We haven’t been as active in offshore markets as the majors, though.

With lower interest rates we expect to see depositors start to assess the risk-return equation and potentially move into equity markets. If credit growth kicks in the eased funding conditions we are currently seeing may turn around as a result.

davison the margin boQ pays for wholesale funding is generally wider than the majors can achieve. so is boQ seeing the same kind of premium having to be paid for deposits over wholesale funding as the majors?n ledInGhaM To some degree ratings also play into the retail market – to a certain extent we, as a smaller regional, pay a premium over the major banks even for deposits. We’ve seen quite a flow of cash in the last couple of months and we are actually starting to see deposit rates ease. But I assume this won’t stay around forever.

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pricing towards TDs, and we have chosen not to chase premiums of 50-100 basis points above benchmark. In fact, our strategy is working – and we are experiencing an increase in requests from new customers to the bank as the froth dissipates and liquidity increases.

davison How does that situation play into expectations of the wholesale requirement going forward?n buShbY As discussed, our liability base is diversified, via operating accounts, TDs and issuance out of Bank of America NA (BANA) negotiable certificates of deposit. Funding via the BANA branch network is currently the most economical form of longer-term funding for the bank. We do, however, have a BANA MTN programme which we can tap if required.

INVESTOR RESPONSE

davison what is the impact of the new shape of wholesale funding requirements on investors’ views on the role of the bank sector in the market overall? a common complaint in the australian investor base always used to be that domestic supply was too heavily weighted to the bank sector. Has this situation eased?n Van KlaVeren The criticism of the Australian credit market historically was that it comprised mainly financials. There was no diversification because most of the issuance was Australian major banks, in unsecured format. Over the last 18 months we have seen quite a number of new corporate issuers. If an investor wants to gain AUD credit exposure nowadays they don’t have to buy just bank paper. Investors have a great choice of relative-value opportunities.

Investors also have a greater choice in terms of where they can invest in banks’ capital structures – including covered, senior unsecured, residential mortgage-backed securities (RMBS) and hybrids.n KaSe We are comfortable with the level of issuance by the Australian banks but we’d still like to see more diversity in the non-financial space. That said, the recent ANZ Banking Group (ANZ) 10-year covered bond provided another point of diversity. Tenor in that asset class is actually beneficial for our multi-asset portfolios, when we want to lock in longer term and spreads.n MIall We still see the transition away from financials as a slowly emerging trend. Corporates are conservatively geared and are therefore doing relatively small deals, which leads to tight pricing. To my mind, investors have to pay up for diversity. And while diversification is desirable it’s just one consideration in our whole investment framework.

At the moment our preference is for financials, although RMBS also look good value considering tenor, credit quality and even liquidity.

Some banks that are in the low single-A category may be sailing close to the wind in terms of ratings for some funds, but there is by no means a blanket restriction in our portfolios.

MIall Over the past 12 months we have seen a great opportunity to pick up one- to three-year paper from global banks. Primary issuance has been affected by the deleveraging of banks in the US, and of course in Europe there hasn’t been much primary around. So we are selectively buying in secondary.

Ratings are a consideration for us when buying offshore names. Looking at Europe versus the US, the US is in a recovery phase and our preference remains jurisdiction by jurisdiction.

n daVISon Does it matter what format offshore borrowers use to access the Australian market – for instance between Kangaroo, domestic branch or global deals?

Van KlaVeren It is worth highlighting the change in US bank issuance, between deals coming out of operating versus holding companies. There is an increasing push by US banks to be issuing out of their holding company rather than the operating entity.

abrahaMS One of the key things that, as intermediaries, we are trying to push is to make sure that big offshore issuers, such as the US banks, come to Australia in Kangaroo format.

Van KlaVeren This comes down to secondary market price support. With global deals there would be predominately international investors who may buy those bonds. This could lead to greater volatility and less liquidity if there is no secondary market support and the local investors do not hold these bonds.

PerICleouS Historically we have not played in global deals. But we will be more open to them going forward.

davison do you have any sense of what is causing the latest wave of cash into deposits?n ledInGhaM I assume part of the driver is a prolonged period of slower credit growth, with borrowers being able to pay down mortgages. Certainly I understand that balance sheets are seeing higher prepayment trends coming through. n bounaSSIf There is also an issue of timing between different banks, based on how they are implementing Basel III. Some banks are being more aggressive than others around the deposits they’re taking on, while others are getting rid of financial institution-type deposits from their balance sheets.

More broadly, in terms of funding, diversity is key. We’ve spent a lot of time on certain market segments, particularly retail, working out how we can better access retail deposits and super funds. The purpose is trying to find niches in deposit growth where historically we haven’t been playing, in order to give an offset for when markets change.n buShbY As an international bank we look for diversification in our liability base. Our operating accounts have grown strongly and behavioural analysis shows long-term stickiness. The Australian banks have been very aggressive in their

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If we moved to a point where we were favouring corporates in relative-value terms, of late there haven’t been many deals larger than A$150-350 million (US$137.8-321.6 million). It would be nice to see corporates doing bigger-sized deals.n Sorrell I would like to see corporates do more, too. For us diversity is still a key issue. One thing I’d mention is that in many cases investors are still close to limit on individual Australian banks – at Tyndall Investment Management (Tyndall), because we have favoured them as a sector for more conservative funds, we are holding those names close to limits in quite a few funds. With this level of exposure we are comfortable to reduce our holdings if they become supply-constrained and expensive.

However, diminished supply will at some point hit us. It is a question of capacity – particularly for Australian financials. There is more room for offshore financials because many of the deals in this sector were issued back in 2007 and have now matured.

OFFSHORE DEMAND

davison How significant is the rise of international demand for australian credit, specifically from the Fi sector?n abrahaMS A key part of our market over the last couple of years is the rise of Asian investors. For instance, Bank of America (BoA) issued in Australia in March this year. A core part of the domestic market supported that transaction but Asian investors played a key role.

This is changing issuer views, too. Five or six years ago if an issuer saw 50 per cent distribution of an AUD deal into Asia they would have complained. Nowadays they thank you. Domestic investors are our key core customers but it is good to have secondary liquidity and a complementary offshore investor base in the market.n buShbY Those investors keep coming back to the market, and while they have participated in deals in the FI space they have also demonstrated an interest in corporates. The yield is the catalyst for investment. n MIall The BoA fixed-rate tranche priced earlier this year was clearly interesting for Asian private banks. Maybe there was some placement of the floating-rate notes (FRNs) as well, but there was certainly a big differential on the street.

n abrahaMS That theme of fixed versus floating rate has happened on a few occasions this year. Where there has been a dual-tranche Kangaroo the fixed-rate piece has tended to go onto the Asian private bank list and quickly disappears. Those investors are crying out for more stock, which is why fixed-rate notes can end up being up to 30 basis points through floaters. The FRN is probably a truer reflection of where the new-issue level might be.

Sorrell How sensitive is asian demand to the level of the currency?n abrahaMS We saw nothing out of the market in June – which was the case in Australia as well – and I must admit I was worried, particularly as the currency went to 92 cents from 104 cents. But the experience in the last few weeks has proved these investors are back. There are long TDs being placed with commercial banks in Asia, and they are reinvesting. I see them as a long-term buyer – further currency drops notwithstanding.n Van KlaVeren Offshore institutional investors and Japanese retail are definitely sensitive to the relative level of the Australian dollar. However, private wealth clients out of Asia are yield-driven. Increased offshore interest is healthy for the local corporate market as it enhances market liquidity. This helps to offset some of the negative effects from the new Basel III rules, in the sense that banks are now less likely to step in to provide liquidity to the market.n Sorrell But offshore participation also creates a risk in the sense that selling pressure could come flowing back to us. We have seen supranational Kangaroos being affected by Japanese flows, for instance, so we have to be cautious. Wider demand is positive, but it is something you have to measure and examine.

davison How are issuers going about engaging with international demand?n bounaSSIf We are not heavily focused on offshore markets. Our main focus is on the domestic market, supplementing our programme in Australia with offshore demand. This at times accounts for 20-30 per cent of individual transactions. Our offshore focus is still in its preliminary stages – we are concentrating on educating offshore investors about who we are and tapping any residual demand, particularly in Asia.n CoYne It is also possible to deliver other product to offshore investors. The RMBS product is a good example. We have seen

“I find it a challenge that a 60-year, non-call five is considered equity for the first five years and debt for the next 55. that seems a bit backwards.”M I h K e l K a S e s c H r o d e r a s s e t m a n a g e m e n t

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some trades, including NAB’s most recent RMBS, that have had foreign-currency tranches. On the senior unsecured side we have seen offshore demand feed through in our trades. I think this theme will continue. n ShaW We saw a lot of international demand in our recent REDS EHP asset-backed deal. That transaction had some certainty around conditional prepayment rate, so it was much easier for buyers to manage if they wanted to swap it back to their own currency.

davison what happens if australia’s rates and yield differentials to the rest of the developed world further erode? richard coyne, nab has seen offshore participation in its wholesale bond transactions increase in recent times. How confident are you that the international bid will remain supportive throughout the different points of the cycle?n CoYne Over the last four years we have seen shifts in asset allocations away from lower-yielding currencies. We think these trends will continue for some time to come. The weaker Australian dollar has led to some concerns that offshore demand would weaken, but to date we are yet to see any evidence that a reversal of international demand is occurring. At this stage we don’t consider this to be a significant risk for NAB. n ledInGhaM We are more focused on the domestic market but we have also tapped the GBP market via our securitisation programme. We have benefited from the UK’s funding-for-

lending programme and the consequent shortage of assets it has caused in the UK market. We are looking at this demand as something we’d like to build on. But there is also an aspect of it that is opportunistic, and which we have to acknowledge will likely go away eventually.

Gribble Joanna bushby, if the australian dollar

depreciates does this make it a more marginal market for issuers swapping funding back to us dollars – simply because the proceeds of a deal would be that much less?n buShbY There are two main priorities for us. One is economics, but secondly and more importantly is diversification of investors. So to some extent it is not really a question of the volume of currency in the book – it is more the diversification of investors. If the currency drops, the economics would become relatively less attractive than they have been. But if we are attracting and broadening our investor base we would in most cases still press ahead with a transaction.n WIttS I think it’s important to note the changing status of the Australian dollar, in that it is becoming a reserve currency for many investors. This won’t change even if it is 15 per cent lower.

If you go back four or five years, if we’d had a similar scenario to what we have recently experienced the Australian dollar would have a 70 handle on it now. The fact that there’s someone on the other side of that trade who is actually buying stabilises the currency.

My feeling is that, in terms of offshore retail investors, we are unlikely to see this paper coming back. If you go back to when Japanese investors started buying Australian dollar paper, 20+ years ago, everyone was concerned about what could happen if the AUD went south. Whereas now AUD/JPY has gone south yet Japanese investors have been buying AUD the whole time.

Mark Abrahams Melissa GribbleSimon Roubicek

nab participants

“the weaker Australian dollar has led to some concerns that offshore demand would weaken, but to date we see no evidence that a reversal of demand is occurring. At this stage we don’t consider this to be a significant risk.”r I C h a r d C o Y n e n a t i o n a l a u s t r a l i a b a n k

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TREASURY CONCERNS

davison it has been suggested in some quarters that banks’ liquidity book managers are likely eventually to be told by regulators to reduce their exposures to other banks. is there any expectation of a liquid assets regulatory change designed to reduce inter-bank exposure?n ledInGhaM Due to changes in Australian Prudential Regulation Authority (APRA) and Reserve Bank of Australia (RBA) regulation, banks will be driven to try and reduce their reliance on wholesale funding. But I’m not sure there will be any change in the types of assets we hold in liquidity books – unless a different type of asset class pops up. n MIall We’ve talked to treasurers and they do not expect any groundbreaking move. They have had a look at their large exposure limits and have not been pushing up against any of them in terms of interbank exposures from cross holdings.

davison when they are disclosed, for instance in annual results presentations, bank liquidity book breakdowns often reveal a substantial portion of self-securitisation. is there any expectation that there will be pushback by the regulators on this asset class, or at least on the volume of it being held?n ledInGhaM My understanding is that self-securitisation is not in banks’ core liquidity but will be included in their liquidity coverage ratios. My sense is that self-securitisation is here to stay.

davison How much thought has gone into how the proposed 5 basis point deposit levy will be provisioned? will banks swallow this cost or pass it on to depositors, for instance via reduced margins?n Sorrell We are talking about a small base and a very specialised area. I think it is such a small size it will be easily absorbed. I don’t expect it will make a significant impact on relative pricing, anyway.

RELATIVE VALUE

davison what views do investors have on the current relative-value situation between bank asset classes?n PerICleouS In terms of capital instruments we see value in old-style lower tier-two and tier-one securities. They trade at multiples to senior unsecured bonds – in fact we think senior paper from major banks is currently expensive.

The old-style lower tier-two notes offer better value than the new-style instruments that have been issued primarily into the retail market and are Basel III-compliant. Our preference is for the old-style lower tier-two and tier-one instruments, particularly the US dollar instruments in lower tier two and the US dollar and euro instruments in tier one.

abrahams when you mention offshore tier one, am i right in assuming you are not referring to the contingent capital – “coco” – bonds?n PerICleouS I am referring to the old-style Australian bank tier-one instruments.

roubicek can you foresee a point at which the new format becomes of interest?n PerICleouS Our funds can take the new, Basel III-compliant format but we do not feel our investors are being compensated for the risk on non-viability. Where would an attractive pricing point be? It is difficult to say because in some regard fixed-income investors are ranking below equity. Investors in the new notes will incur an immediate capital loss upon the occurrence of a non-viability trigger versus investors in the old deals. So there should be a considerable price differential between the old- and new-style instruments. n Van KlaVeren We like covered bonds, we like RMBS and we have also thought for a while that senior unsecured is priced too tight. For the extra bit of spread you get for senior unsecured over covered bonds we prefer to buy the covered and put the extra risk elsewhere, potentially into the corporate space.

We also like the old-style lower tier-two instruments, and we have a preference for some of the offshore tier-one bonds that trade in US dollars and euros over the new-style Basel

“there is not a great deal of transparency on the different types of retail investors in order to understand how sticky they are – versus the benefits of longer-term funding.”h e l e n P e r I C l e o u S a m p c a p i t a l

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III-compliant notes. Like Helen Pericleous, we do not believe investors get sufficiently compensated for the write-down potential. The recent Westpac Banking Corporation (Westpac) new-style tier-two transaction priced essentially on top of where the listed ANZ and NAB old-style lower tier-two hybrid deals were trading – there was no spread differential at all.

With the regulatory push for these new Basel III-compliant bank hybrid instruments to become more equity-like, I’m now not sure if they fit into a traditional fixed-income fund. They are an off-benchmark bet. Therefore, you need to make sure you are sufficiently compensated. n KaSe Our position is not broadly dissimilar to those already described. Across the capital structure we still see value but investors need to be selective. We think RMBS offer a reasonable spread, although we wouldn’t want to buy below 85 basis points over bills given the asset class’s liquidity issues.

We saw the recently issued covered bond by ANZ as reasonably good value. Senior unsecured is probably a bit on the expensive side.

On the subordinated side of things, I don’t think you can price the new-style hybrid structures relative to other debt securities given the equity-like characteristics of the hybrids. In our opinion in the new structures investors are not being adequately compensated for the high amount of risk they are taking when we go further down the capital structure – not only with subordination but also in terms of potential changes in rating agency methodologies.n Sorrell With covereds, RMBS and senior unsecured there are times when any one of them can offer us value, depending on our clients. It is very much a client-based decision. Some don’t want too much RMBS, for example – and they may value triple-A ratings to a greater or lesser extent.

As I have already mentioned, Tyndall is pretty much at limit on many of our bank exposures. This means it is often not attractive for us to go into covereds at the moment, as this could be eating into our ability to invest in senior unsecured.

For us it is usually a question of assessing on a client-by-client basis, although if any one of the asset classes becomes so egregiously mispriced we may find it either extremely attractive or not to be touched.

davison several investors have mentioned potentially seeing value in covered bonds,

which seems to be a step change from where the market was a year or so ago. the old view seemed to be that domestic investors were comfortable with the unsecured risk of domestic banks so weren’t especially interested in a risk-enhanced product unless they saw absolutely compelling value. Has that view really changed?n Van KlaVeren We have not participated in the recent covered bond deals though we bought into the 2012 covered deals by Commonwealth Bank of Australia, Westpac and Suncorp Bank – which have all performed well. We purchased these deals and have held onto the bonds due to their ongoing attractiveness.

When you compare the spread ratio of covered bonds to senior unsecured, the ratio in Australia is a lot higher than what you would find in similarly higher-rated banking systems. Either Australian bank senior unsecured bonds are priced too tight or covered pricing is too wide.

For me, in a total portfolio context, I get better value holding covered and buying high-beta corporate paper rather than buying unsecured bank paper. Unlike Tyndall, we are not anywhere near our limits on Australian bank paper because we believe the Australian bank senior unsecured market has been mispriced for a long time. n PerICleouS We had also not participated in covered bonds for some time. When looking at covered bonds and RMBS the relative value is to the senior unsecured curve of the issuer. We think RMBS should be around 20-30 basis points wider than senior – to account for lower liquidity – while the ratio of covered to senior should be around 60 per cent.

The ratio of the recent 10-year domestic major bank covered bond deal was in line with our target and suited the return hurdles of those funds that participated – hence our participation.

davison How much of that attractiveness was wrapped up in the fact that we are talking about a 10-year deal? n PerICleouS Our participation was purely based on relative value.n Van KlaVeren There is a big shortage of triple-A assets as well. In Australia that universe is the sovereign, semis –

“when you bring a covered bond you have to continue to top up the collateral pool as well, so you end up channelling your mortgages into that pool rather than being able to use them in securitisations. At the moment we see securitisation as a better tool.”t I M l e d I n G h a M b a n k o F Q u e e n s l a n d

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although some of the semis are on negative outlook – secured bank deals and some Kangaroos.

There is a big gap that can be filled in investors’ mandates with further triple-A or higher-rated double-A covereds. We are of the view that a regional bank could bring a covered bond deal, even if it wasn’t triple-A – it just has to come at the

right price. There was some talk last year around potentially bringing a double-A covered, but a new issue was never executed. I believe there is a space for such a transaction. I also don’t think this type of deal would have to be a A$1 billion trade, either – it could be anything from a couple of hundred million dollars.

spreading tHe retail NetAustralian banks have found a happy home in retail for their capital note issuance and for deposit product. Some wholesale market participants believe there would be benefits to tapping retail to fund the full spectrum of banks’ capital structures.

“from A systemAtIc rIsk PersPectIve BAnks need to do more work In dIversIfyIng theIr Investor BAses, esPecIAlly wIth regArd to theIr senIor-unsecured IssuAnce. there mAy Be A greAter oPPortunIty set wIthIn BAnks’ cAPItAl structures thAt retAIl Investors mIght Be Interested In.”

t I M V a n K l a V e r e n u b s g l o b a l a s s e t m a n a g e m e n t

n daVISon Can banks extract more value out of the retail market in their overall funding mix?

Van KlaVeren There is still very much a big concentration of investors who play in different parts of the capital structure. Deposits and hybrids are both fundamentally retail, senior unsecured is wholesale – but largely from bank balance sheets – while covered bonds have more of a diverse investor base.

From a systematic risk perspective banks need to do more work in diversifying their investor bases, especially with regard to their senior unsecured issuance. There may be a greater opportunity set within banks’ capital structures that retail investors might be interested in. Some education probably needs to be undertaken.

I estimate that a sizable percentage of most bank senior unsecured deals are effectively banks funding

banks. There is an inherent systemic funding risk.

n daVISon Retail demand appears to be limited either to higher-yielding product – specifically, subordinated debt and hybrids – or to what is perceived to be risk-free term deposits (TDs). Senior unsecured transactions that have attempted to attract retail investors have not always been unqualified successes. How can banks attract retail to other parts of their capital structures?

Van KlaVeren Education is a big part of the problem. Also, retail investors are not offered senior unsecured bonds, and potentially even residential mortgage-backed securities, as an investment opportunity. In addition, there is a preference from retail investors to buy direct securities rather than gaining credit exposure via a mutual fund. Retail investors need to be educated better with regard to the different investment

opportunity set and how they can gain exposure to this.

Another point to mention is the steeper yield curve. Now that the curve has steepened up, perhaps a five-year senior unsecured bond looks more attractive than a bank deposit.

ledInGhaM The retail fixed-income market has got to become more efficient for us to be able to use it. Currently we can do an accelerated rights issue off lower documentation than we can a senior unsecured transaction. This is ludicrous. One instrument is lower in the capital structure yet that is the one which has less documentation.

Also, the amount we have to pay equity distribution networks makes it uneconomic for us relative to institutional distribution. Tim van Klaveren touched on the understanding of the investor base, and I would add to this the fact that the distribution base is very equity focused. I think distributors need to be trained

to actually distribute fixed income.

WIttS Also on that point, it’s worth noting that we are moving to Basel III-compliant products which include 31-day notice TDs. If I was offered the choice between a 31-day notice TD or a listed retail bond with a five-year credit spread but which also has three-day liquidity, I know which I would choose. I think you’ll see, as the Basel III products start to come in, that there’s a real opportunity for a significant increase in senior unsecured retail bonds.

ledInGhaM Even so, when getting a deal to market there are the same kinds of governance issues with boards around bringing a retail fixed-income issue as you have when bringing an equity issue. You have to take the board through what can be a three- to four-month process to take an issue to market.

ShaW To go through the process you need sufficient volume to get economies of scale, in order to offset all the costs through to distribution. If you’re going to spend three or four months doing a retail-style deal you want to do a couple of hundred million dollars, minimum, to make it worth your while.

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bounaSSIf At the moment it is more economical to issue senior debt to wholesale relative to retail issuance. It costs 40-50 basis points to do a retail transaction, and you have to recoup those costs somewhere. It would be difficult to sell a senior bond structure to retail-type customers based on that pricing differential.

KaSe To some extent all these issues are driven by the arbitrary distinction between retail and wholesale. We have an equity market where retail and wholesale effectively comingle, whereas in the debt markets we have segregated retail and wholesale investors.

Potentially, combining the investor pools could take away many of the factors which lead to retail deals being mispriced, because there would be institutional participation. Retail investors would gain access to all the other parts of the capital structure – not just TDs and hybrids.

While it is possible to buy five-year TDs I’m not sure how many investors actually go beyond three, six or maybe 12 months.

roubICeK If you’re in a five-year floating-rate bond you have liquidity as well, whereas TDs are essentially unbreakable.

PerICleouS Although that liquidity comes at a price. We have some retail lower tier-two notes which are trading substantially wider to where wholesale paper is.

KaSe Is that just because retail investors are searching for yield

so they buy and hold rather than trade, so the securities don’t get marked?

Van KlaVeren I agree that there shouldn’t be an artificial distinction made between the retail and wholesale markets. It shouldn’t cost banks 50 basis points to issue in retail and 2 basis points to issue in wholesale. It should just be one deal that is open to all investors to participate.

PerIClouS Whereas at present there seems to be an arbitrage between issuance in the retail and wholesale markets.

n abrahaMS Would wholesale investors be willing to stomach the volatility that would likely arise if someone sells a large quantity of listed stock 20 basis points away from the action, which changes your mark-to-market? Sorrell I think this issue is somewhat overstated, and in fact retail can sometimes be a provider of liquidity to the market as a whole. Just before the financial crisis we held large positions in subordinated notes which we were instructed to sell in late 2008. We sold well over A$100 million (US$91.9 million), in what was admittedly a very

slow process over a three-month period.

KaSe Volatility is not really an issue from my perspective. It is possible that a small-volume trade can move the market substantially but it is really swings and roundabouts. And if your portfolio is sufficiently diversified it should not be an issue.

I believe all investors should be participating in the same market. It might take a while for everyone to get used to it, but we don’t have segregation in the equity market and that is much more efficient.

Van KlaVeren Most importantly, it is not a healthy situation that banks are funding each other. There should be a broader set of investors throughout the banks’ capital structures. To achieve this banks should potentially be focusing more on the self-managed super fund investors.

CoYne We are always looking for different opportunities to diversify our funding base. To some of the points raised, retail presents a number of additional considerations when compared with wholesale markets.

PerICleouS It is also a question of capacity. How much can retail investors take

up? Which is the most efficient out of senior, tier two or tier one, given that accessing the institutional market in some of those instances is considerably more expensive for banks?

CoYne The retail investor base is important for all the major banks and we have seen a number of tier-one and tier-two trades this year. However, we also recognise that we can’t just rely on one market for these types of product – we need to consider other options. Market capacity is always a consideration and supports the ongoing need for diversification.

KaSe Do issuers think where we are now is as good as it gets? TD rates have been coming down and investors may be full on the tier-one and tier-two securities. Combined with potential change around Basel III, the change of dynamic around offshore funding and the change around cross-currency swaps, is there a danger that funding will become more concentrated?

WIttS In the retail space people are talking about rates staying at a lower level. Yes there is a lag. But retail investors are lengthening their investment portfolios as part of a hunt for yield.

“If you’re goIng to sPend three or four months doIng A retAIl-style deAl you wAnt to do A couPle of hundred mIllIon dollArs, mInImum, to mAke It worth your whIle.”

J a M e S S h a W b a n k o F Q u e e n s l a n d

COVERED PERSPECTIVES

davison the australian covered bond market has to date been the exclusive preserve of the majors and one other bank which is able to sell top-rated product in an economically

efficient way. How closely have issuers explored the potential demand for covered bond issuance below triple-a level?n bounaSSIf We continually monitor the covered bond market. The main constraint for us is balance sheet size, and then transaction size. Although we believe it is possible

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to do a smaller covered bond transaction, economically it doesn’t make sense. If it gets to a point where we think we could offer a decent-sized deal it might work, but currently it doesn’t add up.n ShaW From our perspective we are hopeful that the double-A covered bond market will develop. We look at collateral efficiency. With RMBS we obviously get capital relief if we sell the whole capital structure, and also liquidity relief, so the collateral efficiency is 100 per cent – A$100 of funding for A$100 of assets. From an asset-backed security (ABS) perspective collateral efficiency is around 85 per cent or A$85 of funding for A$100 of assets. For a double-A covered bond it will probably be 80 per cent or less.

The question for us is how we can use our collateral in the most efficient and cost-effective way to deliver to the bank the best cost of funds.n ledInGhaM In addition, it is significant that at the moment we are in a slow credit growth environment. When you bring a covered you have to continue to top up the collateral pool as well, so you end up channelling your mortgages into that pool rather than being able to use them in securitisations. Right now we see securitisation as a better tool.

On the other hand, one benefit for any regional in issuing a double-A rated covered bond would be the ability it should offer to drive more duration in the funding profile, and providing more diversification in the funding toolkit.

davison richard coyne, nab has not to date issued into the australian dollar covered bond market, making it the only one of the domestic big four only to have issued the product offshore. what is the thinking behind this strategy, and how likely is it that you will look at the domestic covered bond market in future? n CoYne We look at our term funding options in two segments: unsecured and secured. Under secured we combine covered bonds, RMBS and ABS. In terms of secured funding NAB has been active domestically in both RMBS and ABS – the latter via the Medfin ABS offering in September 2012.

NAB has also been an active offshore issuer of covered bonds with a focus on achieving duration. In this context, seeing a substantial transaction of 10-year duration in the

domestic market is an interesting development. Having the ability to offer a triple-A rated product and achieve duration in the domestic market is a positive development.

davison one challenge for bank issuers with smaller funding requirements is that some offshore benchmark markets, such as euro covered bonds, have an expectation of regular, sizeable issuance – which might be hard to fulfil under all circumstances. How much harder is it for a borrower like boQ to access those benchmark markets, given that issuing €500 million (us$666.7 million) a year would presumably take out a substantial portion of your wholesale funding requirement?n ledInGhaM This is one reason why, for us, covered bond transactions would likely be restricted to the domestic arena: we do not have the balance sheet size necessary to continue to feed the expectations of the investment markets in Europe and the US. A domestic covered bond transaction is something we may be focused on – but not something we will do imminently.n WIttS There is another side to relative value and that is predictability – a known product, with certainty of supply. ING Bank Australia has now brought seven RMBS transactions to market. In every one the portfolio of underlying assets was broadly the same. They have all been really ‘boring’ – and investors really liked them. Investors know the product and brand, and they know there is certainty of supply coming through.

We have not done a covered bond but we continue to look at on- and offshore options as part of the funding mix – especially in terms of getting duration into the portfolio.

davison we have seen canadian banks issue covered bonds into the australian market. How realistic is the possibility of us-origin covered bond issuance denominated in australian dollars? n buShbY All funding and liquidity options are thought through, but issuance of covered bonds is not on the short-term horizon.

“offshore participation also creates a risk in the sense that selling pressure could come flowing back to us. wider demand is positive, but it is something you have to measure and examine.”J o h n S o r r e l l t y n d a l l i n v e s t m e n t m a n a g e m e n t

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LIQUIDITY CONSIDERATIONS

davison to what extent do liquidity expectations on the part of investors contribute to their relative-value assessments? For instance, prior to the rmbs spread rally the australian market witnessed earlier this year local investors had often suggested that primary securitisation margins were lagging – in part because the secondary market for the product was challenging. is this view still valid?n Van KlaVeren In terms of required liquidity premium there are two components: the ability to trade and the cost of trading. Over the last eight months RMBS liquidity has improved substantially on both fronts. However, once the QE tap is turned off liquidity premia may rise again.n Sorrell From our perspective one of the challenges with the RMBS market has been that, even until the last few years, it was still suffering from oversupply. That oversupply has diminished and the market has since become more orderly.

davison does liquidity premium for asset classes have an impact on economics for issuers? For instance, given a choice between issuing one instrument with a substantial illiquidity premium and another without, are the relative economics altered sufficiently to change the decision?n WIttS We have seen a rebuilding of bank balance sheets where retail is ‘good’ and wholesale is ‘bad’. And we have now got to a stage where banks are beginning to question the economics of paying for six months what they could be paying for six years.

There are pure economic reasons to go to one market over another, and there are also overarching strategic reasons why you want to be seeking one funding strategy over another. There will be times when an issuer has to tap into more expensive markets for diversity and there will be times when the same issuer has to leave something on the table for the next one to come to market.

FUTURE FUNDING MIx

davison it seems to be a reasonable assumption that in the foreseeable future there is not likely to be a regulatory change in direction in terms of a softening of the stance on the fundamental instability of wholesale funding. without this sort of change, is there any prospect in future of banks being able to adjust the weightings between deposit and wholesale funding?n WIttS If the base case is that all retail is good and all wholesale is bad, the danger is that some retail funding potentially becomes unstable. This is counter to what the regulator is attempting to achieve. There is a learning curve that markets will go through, particularly as we go through Basel III implementation and dry runs of the RBA’s committed liquidity facility.n Van KlaVeren Look what happened in Cyprus: too many deposits can be a bad thing too. If you have no debt in the capital structure there is no loss absorption if a bank fails. It is a fine line between wholesale funding – which can be perceived to be loss absorbent – versus deposits – which cannot. n WIttS Retail investors follow a name, not a balance sheet. That was certainly the case in Cyprus.n ledInGhaM It is about having a balanced mix between the levels of wholesale and retail funding. The structural changes that have happened in the retail deposit market mean that, if you were totally retail funded at that point in time, it would have cost you more than having a balanced mix of retail and wholesale. n PerICleouS Our market does not differentiate between retail depositors. Or at least there is not a great deal of transparency on the different types of retail investors in order to understand how sticky they are – versus the benefits of longer-term funding.n ledInGhaM This is a distinction between contractual maturity and behavioural maturity. Banks manage maturity transformation on a daily basis – that’s the nature of their business. A contractual maturity can be broken. Under Basel III you will get penalised if you break TDs, but not all those deposits are certain to flow out in a crisis. •

“we have seen a rebuilding of bank balance sheets where retail is ‘good’ and wholesale is ‘bad’. And we have now got to a stage where banks are beginning to question the economics of paying for six months what they could be paying for six years.”M I C h a e l W I t t S i n g b a n k a u s t r a l i a