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Challenge remains of aligning tax with Australia’s financial system objectives

Negative gearing, tax on superannuation and dividend imputation are all up for discussion, but the prospects for overhaul are complicated

by the implications of change. Despite speculation that the federal government might bow to pressure over negative gearing, Australia’s tax white paper process has so far effectively defended the role of negative gearing on residential property investment.

Industry figures are also lining up to defend the existing tax system. Ken Morrison, Sydney-based chief executive officer at the Property Council of Australia, argues that negative gearing is not just a property-specific part of the tax spectrum, nor does it explain the country-wide distortions in the housing market.

Morrison told a second-quarter industry event in Sydney: “Negative gearing is overwhelmingly used by middle-income bracket people… with 91 per cent of these having just one or two investment properties. These people are looking to save and invest for their futures and see negative gearing as a way to get onto the property ladder. Overwhelmingly, these negative gearing situations turn positive in the future.”

However, other influential figures are quite forcefully making the argument that the government should re-examine negative gearing. John Daley, chief executive officer at the Grattan Institute in Melbourne, comments: “If the best argument we can come up with for negative gearing is that it looks after middle-income Australia, it is a policy which is in deep trouble.”

Daley acknowledges that the largest number of people who use negative gearing are on middle incomes, but he says

most of the dollar value of capital gains goes to people on higher incomes. “If we are really trying to look after people on middle incomes, reducing the marginal tax rate would be a much more effective way of going about it,” Daley insists.

Miranda Stewart, director in the Tax and Transfer Policy Institute at the Australian National University in Canberra, also sees a distortionary impact – noting aspects of housing investment which she believes are beginning to make negative gearing operate as a tax shelter. She comments: “Most other countries, to some extent, have constraints around this particular type of taxation. I am not at all suggesting we completely abolish the deductibility of interest… But I think it is important to put some limits in place.”

Dividend imputationAnother potentially distortionary tax is dividend imputation, which offers local retail investors preferential tax treatment for Australian equity dividends. The value of dividend imputation has been called into question on several occasions, including by the 2010 future tax-system review and last year’s final report of Australia’s financial-system inquiry.

The 2015 Australian tax white paper agrees that the purpose of dividend imputation is worth exploring, and participants at the Sydney conference agree. They argue that despite clear demand from prospective retirees for dividend imputation credits, imputation is not a structure conducive to efficient corporate taxation, particularly in a global capital market.

“At one time dividend imputation was very fashionable among tax administrations, but nowadays very few countries offer it,” confirms John Piggott,

director and professor of economics at the University of New South Wales in Sydney. “I’m not suggesting we should move with great haste, but I believe [its] days are numbered.”

The thirst for franking credits acts as a significant incentive for Australian-owned corporates to continue offering them. This in itself poses problems, explains Rob Heferen, executive director, revenue at the federal Treasury in Canberra.

He comments: “In the US there is considerable literature that says retained earnings are the most efficient form of capital for productivity. What the Australian system says is the market is the one that is going to determine where capital is invested. As a shareholder there is a benefit to fully franked dividends, but there is also a sense of taking the company to account – and this is a very powerful driver on the investment highway.”

Australia is an outlier in its retention of a dividend-imputation regime, but this alone may not necessarily be a reason to call for change. Stewart says: “A reason European countries have ceased their franking systems is because of a European Court of Justice ruling about the operation of cross-border imputation in the common market. In Australia we are not subject to this constraint.”

Meanwhile, Australia’s deputy treasurer, Josh Frydenberg, confirms government plans to re-examine the superannuation regime. “Pensions are currently the largest single expenditure item, and this is growing quite rapidly,” he says. “We are obviously giving some thought to having a broader retirement-incomes policy examination because effectively the Holy Grail is the interaction between the systems of taxation, superannuation and pensions.” •

The review of Australia’s tax system continues to attract interest and comment from senior financial markets figures. But the tone of the debate is lending substantial support to the status quo in areas which influence national asset allocation.

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APRA says “common sense sometimes absent” from ADIs’ mortgage-lending assessments

Byres disclosed significant detail around one specific test to which APRA subjected a number of “larger housing lenders” as part of the

review of mortgage-lending standards the regulator initiated in December last year. The test required lenders to submit their serviceability assessments for four hypothetical borrowers: two owner occupiers and two property investors.

Disconcerting differences“The outcomes for these hypothetical borrowers helped to put the spotlight on differences in credit assessments and lending standards. The outcomes were quite enlightening for us – and, to be frank, a little disconcerting in places,” Byres said.

APRA discovered that mortgage lenders’ assessments of borrower risk feature “wide differences”, resulting in what Byres called a “surprising result” in terms of how much ADIs were willing to lend. “It was not uncommon to find the most generous ADI was prepared to lend in the order of 50 per cent more than the most conservative ADI,” Byres revealed.

The APRA test uncovered a number of areas in which Byres suggested the regulator found some lenders’ assessments to be insufficiently conservative. One “major concern” is that a number of ADIs made credit assessments based on a lower level of borrower living expenses than that declared by the borrowers themselves.

Byres revealed: “Best practice – and intuition – would be to apply minimum living expense assumptions that increase with borrower incomes; this was a

practice adopted by only a minority of ADIs in our survey.”

Some lenders are also too lax in terms of how they assess other income sources, such as bonuses, overtime and investment earnings. “Common sense would suggest it is prudent to apply a discount or haircut to these types of income, reflecting the fact they are often a less reliable means of meeting regular loan repayments,” Byres argued. “Unfortunately, common sense was sometimes absent.”

Elsewhere, APRA found some ADIs applying smaller haircuts than the industry-standard 20 per cent – or even no haircut at all – on borrowers’ declared rental income, and some applying no interest-rate buffer to investment borrowers’ existing debts.

On this latter issue, Byres said: “I confess to struggling to see the logic of such an approach – after all, any rise in interest rates will at some point in time affect the borrower’s other debts just as they will for the new loan being sought.”

Finally, the APRA test uncovered some ADIs using overly generous projections of borrowers’ servicing of loans with interest-only periods. Even with a five-year interest-only period at the start of a 30-year mortgage, Byres revealed, the majority of lenders assumed principal and interest repayment over the entire 30 years – and “hence were able to inflate the hypothetical borrower’s apparent surplus income by, in our particular example, around 5 per cent”.

Action pointsAPRA’s next course of action is likely to remain at the micro, issuer-specific level. For one thing, Byres confirmed that “Australian

ADIs are thankfully well away from the types of subprime lending that have caused so many problems elsewhere, [such as] lending with a loan-to-value ratio in excess of 100 per cent, at teaser rates [or] to borrowers with no real capacity to repay”.

Byres highlighted system-level regulatory options potentially available to APRA, including: “Additional supervisory monitoring and oversight, supervisory actions involving pillar-two capital requirements for individual ADIs, and higher regulatory capital requirements at a system-wide level. Beyond this, there are more direct controls that are increasingly being used in other jurisdictions, such as limits on particular types of lending – what are commonly referred to as macroprudential controls.”

However, he also pointed out that the Australian regulator has to date “opted to stick with traditional microprudential tools targeted at individual ADIs and their specific practices”. And he suggests that, at this point, the same strategy will be deployed to correct issues identified by the lending standards review.

APRA’s goal is not to standardise mortgage-lending standards. Byres said the regulator expects ADIs to adhere to “some minimum expectations” around things like interest-rate buffers and floors, and to “adopt prudent estimates of borrowers’ likely income and expenses”.

But he was also quick to point out: “We certainly want to see competition between lenders and fully accept that different ADIs can have different risk appetites. And we are not seeking to interfere in ADIs’ ability to compete on price, service standards or other aspects of the customer experience.” •

Australian Prudential Regulation Authority (APRA)’s chairman, Wayne Byres, suggested in a May 13 speech that the regulator is far from universally happy with the way all authorised deposit-taking institutions (ADIs) calculate borrowers’ likely ability to service mortgage debt.

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KangaTrendsKanga

Reporting season shows major banks diverging on capital strategy – for now

Meanwhile, one of the majors quantifies a negative impact on treasury income which it suggests has primarily

been driven by Australia’s newly restrictive liquid asset regulations.

ANZ Banking Group (ANZ) and Westpac Banking Corporation (Westpac) appear to be broadly comfortable with their level of capitalisation. Indeed, both banks actually saw their common-equity tier-one (CET1) ratios fall slightly over the six months to the end of March this year, although they have also each announced plans to bolster organic capital generation through their dividend reinvestment schemes (DRSs).

Following its May 4 results announcement, Westpac noted in a letter to shareholders that “there is some regulatory uncertainty over future capital requirements” and announced plans to apply a 1.5 per cent discount to the market price of shares issued under its DRS and to partially underwrite the scheme.

ANZ is offering the same discount to market price in its DRS, but not the underwriting element. ANZ’s results announcement on May 5 describes capital calibration as a balancing act, saying

the bank “seeks to manage shareholder returns while funding growth and progressively adjusting to any changes to regulatory capital requirements”.

An analyst note from Westpac Institutional Bank suggests: “ANZ believes it is currently adequately placed and that any changes to capital requirements will be phased in gradually, and therefore [it is] in no rush to increase capital levels.”

By contrast, National Australia Bank (NAB) used its May 7 results announcement as an opportunity to announce a A$5.5 billion (US$4.3 billion) rights issue which it expects to catapault its common-equity tier-one ratio well ahead of those reported by ANZ and Westpac (see table on this page).

NAB has specific reasons for a near-term capital raising – its chief executive, Andrew Thorburn, said in results commentary that the rights issue “facilitates our proposed exit from the UK banking business”.

However, the bank is also pitching the capital raising as an exercise in prudent balance-sheet management. Thorburn added: “A strong balance sheet has always been a priority at NAB… [the rights issue] positions us ahead of anticipated regulatory changes.”

Commonwealth Bank of Australia has a different reporting calendar, but on May 6 it provided a capital-adequacy update for the three months to the end of March. In this, the bank disclosed a CET1 ratio of 8.7 per cent, down from 9.2 per cent at the end of calendar 2014.

Although NAB is currently an outlier in terms of its decision to actively raise capital, many analysts believe looming regulatory impositions mean further capital issuance is a matter of when and not if. For instance, writing of the NAB rights issue, Mark Bayley, credit strategist at Aquasia, argues: “The pain in the banking sector is unlikely to get better soon… I’m sure that this capital raising will not be the last.”

Liquidity managementThe three majors disclosing half-yearly results at the start of May also all report successful transition to the new liquid assets regime, including the use of committed liquidity facilities to make up the shortfall in high-quality liquid assets (HQLAs) required to meet liquidity coverage ratios (LCRs). All three were well above the 100 per cent LCR requirement by the end of March, with buffers of nearly 20 per cent established.

However, the transition has not come without cost. Westpac reported a A$47 million fall in treasury income for the half-year ending March 31 relative to the preceding six months – or a A$180 million fall year-on-year.

The bank says: “Returns on the liquids portfolio have been [affected] by the introduction of the LCR, which requires a significant portion of the group’s liquid assets to be held in low-yielding HQLAs, which are largely long-term holdings and not actively traded.” •

Half-yearly results announcements from three of Australia’s big-four banks shone light on approaches to capital management which have started to diverge, at least for the time being. Analysts believe, though, that further increases to capital levels are only a matter of time.

MAJOR-BANK REPORTED CET1 LEVELS AND PLANNED INCREASE

BANK CET1 AT 30 SEP 14 (PER CENT)

CET1 AT 31 MAR 15 (PER CENT)

PRO-FORMA CET1 AFTER NAB RIGHTS ISSUE (PER CENT)

ANZ Banking Group 8.8 8.7 N/A

Commonwealth Bank of Australia

9.2* 8.7 N/A

National Australia Bank 8.6 8.9 10.3

Westpac Banking Corporation

9.0 8.8 N/A

* At December 31 2014.

SOURCE: AUSTRALIAN SECURITIES EXCHANGE MAY 2015

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Green-bond investors should have skin in the game, key market player insistsInvestor and intermediary participants in the Australian domestic market’s latest green-bond transaction identify increasing demand for deals even beyond specialist socially responsible investment (SRI) portfolios.

Nor should it be necessary for green bonds to price tighter than vanilla bonds in order for the green-bond market to grow. In fact, one investor

insists this is a product in which the buy side should have skin in the game.

On May 27, ANZ Banking Group (ANZ) priced its debut, self-led Australian dollar green bond – a A$600 million (US$464.7 million), fixed-rate, senior-unsecured deal with five-year tenor. This is the second green bond to be issued by an Australian company in the domestic market, after National Australia Bank (NAB) priced A$300 million of green bonds in December last year.

The transaction was announced as a benchmark with the intention of pricing a

minimum of A$500 million, Paul White, global head of debt syndicate at ANZ in Sydney, tells KangaNews. The targeted buyer base was a combination of specialist SRI funds and also ANZ’s existing senior-unsecured investors.

White reveals the order book reached A$725 million from nearly 50 investors. “We saw a number of smaller tickets from new investors with ethical and environmental, social and governance mandates – particularly from the middle market, councils and universities. However, the larger orders were some of the key existing buyers of ANZ paper.”

Deal data reveal that 92 per cent of the transaction was placed with domestic accounts and the remainder went into Asia. The book was diverse: by type, asset managers took 56 per cent, insurers 21 per cent, middle market 7 per cent, banks 6 per cent, councils 3 per cent, central banks 3 per cent, semi governments 3 per cent and private banks 1 per cent.

According to KangaNews data, ANZ’s deal is the largest fixed-rate issue in the Australian market by a financial institution in 2015, and it matches a KfW Bankengruppe Kangaroo green bond as Australia’s largest such issue.

Luke Davidson, Melbourne-based head of group funding at ANZ, reveals that the bank was confident about the outcome ahead of the transaction. He

comments: “During our conversations with investors in the last six months we received increasingly positive feedback on the product. Given this obvious investor demand and ANZ’s objectives around sustainability it was a straightforward decision to support the market with a transaction of our own.”

Pricing debateThe transaction priced in line with ANZ’s senior-unsecured issuance, White confirms. The green-bond spread was the same as that achieved by NAB on its A$1.9 billion five-year floating-rate note

(FRN) priced May 26 – and just inside the A$2.5 billion, five-year FRN ANZ printed at 82 basis points over bank bills in April.

Discussion about the appropriate pricing of green bonds relative to mainstream issuance continues. Gary Brader, group chief investment officer at QBE Insurance (QBE) in Sydney, argues that it should not be necessary for green bonds to price tighter than standard deals in order to offer issuers a genuine incentive to have greener lending books.

He explains: “As an investor we are fortunate that the reality of the marketplace for this sort of instrument is that we don’t sacrifice anything to be involved. We can achieve ANZ risk at ANZ pricing, and we are doing some broader good as well.”

Meanwhile, Davidson suggests demand for green bonds is already sufficient to influence lending strategies. “There are two sides of the equation when it comes to the development of the green-bond market – investor demand for green bonds and customer demand for financing green projects,” he explains. “Based on the feedback we’ve received to date, we’re confident investor demand is growing – and this should allow ANZ to increase funding allocated to green projects in the future.”

But Brader also believes there may be more investors can do. “This is a deal

“BASED ON THE FEEDBACK WE’VE RECEIVED TO DATE, WE’RE CONFIDENT INVESTOR DEMAND IS GROWING – AND THIS SHOULD ALLOW ANZ TO INCREASE FUNDING ALLOCATED TO GREEN PROJECTS IN THE FUTURE.”LUKE DAVIDSON ANZ BANKING GROUP

9

where investors get something free, while the issuer handcuffs itself in terms of how it must use the proceeds. QBE is not averse to exploring a structure with issuers where investors also have a little skin in the game.”

Brader confirms that QBE’s participation in the ANZ transaction forms part of its broader investment mandate – in other words, not as part of an SRI portfolio. He tells KangaNews: “QBE seeks strong risk-adjusted returns and the ANZ transaction provided these. Similarly to our involvement in social impact investing, the notion of SRI resonates with QBE’s customers, policy holders and shareholders. We participated in the ANZ transaction because we were comfortable with the credit and the price. This bond makes a difference, so it’s a win-win-win.”

Liquidity mattersANZ’s green bond is eligible for the Barclays MSCI green-bond index, White confirms. He also says the lead manager will actively support the bonds in the secondary market, which it believes should help to alleviate investor concerns

around liquidity which were evident at the investor meetings.

“Liquidity was mentioned repeatedly during the roadshow,” White says. “For this reason investors made it clear they were seeking a deal of benchmark volume. Given the strong focus on liquidity it was particularly pleasing to see the transaction exceed the benchmark size and for it to become part of the index. ANZ will look to make secondary markets in this bond to offer additional liquidity.”

BT Investment Management (BT) has participated in both domestic green bonds to date, the firm’s Sydney-based

portfolio manager, George Bishay, reveals. He explains that he was unsure what secondary-market liquidity would be like when the NAB deal printed and therefore only bought the bond for BT’s SRI funds. But he adds that he has seen solid performance since pricing, with secondary demand in evidence.

Liquidity in the portfolio is a relevant consideration but not an overwhelming priority, QBE’s Brader argues. Even so, he insists the ANZ deal comes with little-to-no liquidity concern. “We are comfortable sacrificing liquidity for yield in a portion of the portfolio. However, I don’t think in this particular instance we are necessarily sacrificing liquidity – it is a decent-sized deal and the investor pool that was attracted to it was a little larger than a green bond may otherwise draw. It is plausible to believe liquidity in this instrument may not be any less than a vanilla ANZ bond.”

However, Justin Davey, Sydney-based portfolio manager at BT, says there remains a reason to think green bonds may be more tightly held than mainstream issuance – although the same factor drives price performance.

“These bonds generally remain buy and hold at the current time, and I’m not certain SRI funds are necessarily looking for high levels of liquidity,” Davey comments. “However, theoretically it would be possible to put the green bond back into the market as easily as if it were a regular senior bond. The argument is that the green bond, due to scarcity value, could outperform its peer over time.”

Verification preferenceThe portfolio behind ANZ’s green bond comprises loans to wind and solar power projects and Green Star-rated commercial

property buildings in Australia, New Zealand and parts of Asia. The bond has been certified by the Climate Bonds Initiative (CBI) and independently verified against CBI standards by Ernst & Young (EY), ANZ revealed prior to the bond’s launch.

White says there was a strong investor preference for the transaction to have an independent third party which verified its compliance with CBI standards. “We identified an existing pool of around A$1.1 billion of eligible assets, predominantly in the wind farm, solar energy and green-buildings sectors. The assets may change over the course of this, or any subsequent, bond issue but the post-deal assurance provided by EY against standards issued by the CBI will be reviewed after the first six months and then annually until maturity. We will also be fully transparent with the asset pool.”

While not a requirement of issuance – issuers can self-certify green bonds – third-party certification provides additional investor comfort. “The feedback received from investors is that independent verification is very important, and we view

it as important for the development of the market that there are no questions about integrity,” Davidson reveals.

Brader agrees. “This is a governance check that ensures we aren’t just accepting the bond is green – it means it stands its ground in terms of external scrutiny.”

However, Davey argues that given the green-bond market is nascent, investors may at this stage have different requirements around what is acceptable or best practice among the various levels of certification. “At this point in time most investors are using common sense to judge this,” he tells KangaNews. •

“THIS IS A DEAL WHERE INVESTORS GET SOMETHING FREE, WHILE THE ISSUER HANDCUFFS ITSELF IN TERMS OF HOW IT MUST USE THE PROCEEDS. QBE IS NOT AVERSE TO EXPLORING A STRUCTURE WITH ISSUERS WHERE INVESTORS ALSO HAVE A LITTLE SKIN IN THE GAME.”GARY BRADER QBE INSURANCE

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FIRST MUTUAL TIER-TWO ISSUER SEES AUSTRALIA’S WHOLESALE MARKET EXPAND FURTHER

Heritage Bank tells KangaNews how it overcame the challenge of accessing the market,

including the process of using write-off as its non-viability option.

On June 17, Heritage Bank priced a new, A$50 million (US$38.7 million) tier-two transaction under wholesale documentation. The sub debt, which has an investment-grade rating of Baa2/BBB from Moody’s Investors Service and Fitch Ratings (Fitch) respectively, priced at 350 basis points over bank bills.

This is the first instrument of its type to be issued by an Australian mutual bank and consequently the first Australian tier-two deal not to incorporate an option to convert to equity in the event of non-viability.

The closest precedent was likely the A$300 million tier-two issued by the unlisted ME Bank – now known as ME – in August 2014. It priced at 270 basis points over bank bills. However, it is not a direct comparison for Heritage Bank as it offers conversion to non-voting equity in the event of non-viability

Paul Williams, chief strategy and investment officer at Heritage Bank in Toowoomba, tells KangaNews the issuer had two options for its tier-two transaction. It could use a mutual equity-interest instrument, an approach which has been specifically

incorporated into prudential standards by the Australian Prudential Regulatory Authority (APRA). Alternatively, it could use a write-down only structure.

TAX HURDLESThe challenge with the latter was the possibility that doing so might incur tax consequences at the point of non-viability, and therefore ran the risk of only being afforded 70 per cent of prudential capital benefits by the regulator for each A$1 issued. “We really wanted to use the write-down structure but had to build an argument to convince APRA there was no tax liability,” Williams explains.

In order to overcome this challenge, and under the guidance of the issuer’s legal adviser, Ashurst, Heritage Bank embarked on a 16-month process whereby it engaged with the Australian Taxation Office (ATO) to obtain a private binding ruling, and subsequently negotiated with APRA to achieve its preferred outcome.

“There was no guarantee of success when we took the private binding ruling to APRA,” Williams reveals. “But the regulator was very engaged and constructive throughout the process and after a few months of dialogue it was signed off.”

As a result the notes satisfy the non-viability requirement specified under

Basel III solely through a write-down clause, but can also count 100 per cent of the face value issued as regulatory tier-two capital.

“It is a difficult concept to explain and some of the discussion I’ve seen on the topic is confusing. A bank has to suffer sufficient losses before APRA considers an issuer to be at the point of non-viability,” Williams explains. “Only then is the instrument at risk of being written down.”

The new structure does not appear to have discouraged investor interest in the transaction. Following a domestic roadshow in Sydney and Melbourne, Williams says the deal saw participation from 14 investors comprising two “key domestic institutional players”, middle-markets accounts, private banks and some offshore buyers.

Williams comments: “It is a new structure so it was always going to require clarification. Also, given it was a small deal, we had to answer questions about liquidity. Ultimately there was an obligation to ensure investors were comfortable with the risks they were taking on.”

He adds that Heritage Bank’s balance sheet helped. “We have a very strong asset base and, although we are not as frequent an issuer as we’d like, we got help from our lead managers and the deal was fairly priced.” •

Australia’s first Basel III-compliant tier-two deal from a mutual bank represents a development of the market to accommodate new players, the issuer says. The deal also diverged from the local market’s convention on loss-absorption mechanics.

“IT IS A NEW STRUCTURE SO IT WAS ALWAYS GOING TO REQUIRE CLARIFICATION. ALSO, GIVEN IT WAS A SMALL DEAL, WE HAD TO ANSWER QUESTIONS ABOUT LIQUIDITY. ULTIMATELY THERE WAS AN OBLIGATION TO ENSURE INVESTORS WERE COMFORTABLE WITH THE RISKS THEY WERE TAKING ON.”PAUL WILLIAMS HERITAGE BANK

1 1

BOQ deal marks next step for Australian wholesale tier-one

On May 15, BOQ priced A$150 million (US$116.2 million) in a new wholesale-only additional-tier-one transaction. The deal has

a mandatory conversion date in May 2022 and pricing of 435 basis points over bank bill swap rate (BBSW). Joint lead managers were Deutsche Bank, National Australia Bank (NAB) and Westpac Institutional Bank (Westpac).

Tim Ledingham, treasurer at BOQ in Brisbane, says recent market fundamentals attracted the borrower to explore wholesale issuance in new-style format, including the fact that the unlisted market was cheaper in terms of fees and legal costs. “We were attracted by the efficiency of this streamlined format for an issuer of our need: for volume of A$150 million it is not always necessary to go to the listed market.”

Institutional participation revealedBOQ’s deal is just the second domestic wholesale-only tier-one issue by an Australian institution in the Basel III era. In March this year, AMP priced A$275 million of hybrid notes at 400 basis points over BBSW.

KangaNews understands middle-market buyers have featured prominently in these deals’ books, though at the time of the AMP deal market participants were reluctant to reveal the precise level of fund-manager participation. However, Nick Chaplin, Sydney-based head of hybrids and structured capital origination at NAB, now tells KangaNews eight institutions participated in the AMP transaction for around 27 per cent of final volume.

The institutional bid for BOQ’s deal was lower: issuer and leads reveal that fund

managers bought around 16 per cent of this trade. Even so, they argue that given the instrument was rated BB+ by Standard & Poor’s Ratings Services, compared with AMP’s BBB, this was to be expected. “This level of rating will instantly have implications for mandates for certain institutional buyers,” Chaplin insists.

Allan O’Sullivan, executive director, frequent borrowers and syndicate at

Westpac in Sydney, agrees that the difference in deal ratings was important to institutional investors. As an issue out of the group entity, AMP’s tier-one is three notches below the issuer’s standalone rating. As an authorised deposit-taking institution, BOQ’s security rating was subject to a four-notch reduction.

“We knew going into the transaction there was going to be a structural challenge around which institutions could fully value the franking credit,” O’Sullivan reveals. “Adding this to the sub-investment grade security rating helped frame expectations around likely institutional participation.”

O’Sullivan explains that fund managers’ ability to value equity franking credits varies. This very much depends on who the downstream investors are and whether they can capture franking value – while others make an investment decision on the basis of the net cash return versus internal performance hurdles.

Australia’s wholesale tier-one market took another developmental step in mid-May, as Bank of Queensland (BOQ) issued the Australian market’s second such deal in the post-crisis era.

Support growsIntermediaries insist support for non-listed tier-one is growing, even though this might not be immediately apparent in primary-market volume terms. Instead, intermediaries point to secondary-market activity as an indicator. “It was pleasing to see buyers participating in the BOQ tier-one instrument that have either bought the AMP deal as a primary issue or traded into it subsequently,” Chaplin tells KangaNews.

He says performance has been solid, particularly compared with listed deals, while liquidity has also held up. “We have seen strong market volumes go through for AMP and the margin has traded in – to around 390 basis points over bank bills from 400 basis points over bills at launch,”

Chaplin reveals. “Yet over the same period major-bank listed tier-one issuance has widened a little.”

Ledingham also notes that at this relatively early stage in the tier-one wholesale market’s development it appears to have some positive secondary-market performance indicators. “Listed-market volumes can be quite light and this can cause some noise in terms of mark-to-market value,” he says. “Anecdotally, the unlisted market may provide true liquidity on a daily basis.”

O’Sullivan says the 435 basis points over BBSW price guidance for BOQ was generally seen as fair. He explains: “If you accept the fact that the market has repriced on the back of perceived regulatory risk associated with potential changes to risk-weighted asset methodology and expected higher CET1 capital buffers, where we set the price on BOQ was reflective of the extent to which the secondaries had moved.” •

“WE WERE ATTRACTED BY THE EFFICIENCY OF THIS STREAMLINED FORMAT FOR AN ISSUER OF OUR NEED: FOR VOLUME OF A$150 MILLION IT IS NOT ALWAYS NECESSARY TO GO TO THE LISTED MARKET.”TIM LEDINGHAM BANK OF QUEENSLAND

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Domestic market on the global map as 10-year corporate issuance simmersClear and decisive engagement with the domestic corporate market assisted Australia’s newest long-dated corporate issuer to reach record-breaking volume heights, market participants insist.

Value assessments on Asciano Finance (Asciano)’s 10-year transaction vary, but volume – which the issuer says far exceeded expectations –

supports belief that the domestic option can feature in the global mix.

Asciano priced its debut Australian dollar deal on May 12, bringing the largest 10-year deal for a corporate borrower since 2007. The company issued A$350 million (US$271.1 million) of bonds at 215 basis points over swap – 5 basis points inside guidance – via leads ANZ, Citi and Westpac Institutional Bank (Westpac).

The most recent Australian issuer of 10-year bonds was Queensland Motorways (QM), in December last year. But sizeable

Australian issuance at this maturity is rare: the number of substantial post-crisis transactions is less than a dozen.

Time is rightAsciano was keen to achieve 10-year tenor. This is almost uncharted territory in the Australian market and issuing in 10 years is therefore perceived by some issuers as coming with execution risk attached.

Asciano’s EMTN programme is structured so the company can issue bonds in Australia or offshore. This assisted the borrower in terms of minimising domestic-market execution

risk. If appetite had proved lacklustre the issuer could simply have gone offshore, Joanna Wakefield, group treasurer at Asciano in Sydney, explains.

However, Wakefield had a strong hunch that conditions were accommodative for a robust 10-year domestic deal. She tells KangaNews: “I believed the time was right to execute a 10-year domestic deal but was able to commence the process knowing we could access offshore markets if we found this was not the case. We were very clear with the domestic investor base that 10 years fits our maturity profile and therefore seven years was not an option. I think it was partly this honesty that helped drive the transaction forward.”

The issuer’s clear support of the development of the domestic market was another driver, argues Daniel Leong, associate director, debt capital markets at ANZ in Sydney. “The company made it very clear to investors during its roadshow that it believed the Australian dollar market had matured sufficiently to allow a 10-year trade. The issuer has a need for long-dated funding to match its asset profile, and it always had an intention to access domestic investors when market fundamentals allowed.”

Leong adds: “In the past 3-4 years the seven-year market has developed.

Now the hope is for 10 years to gain similar depth.”

The deal was a chance to invest in a company with an improving profile, Ian Campbell, capital markets origination director at Citi in Sydney, adds. “Asciano has gone through a restructure of its business and is performing strongly, receiving a ratings upgrade from Standard & Poor’s Ratings Services to BBB from BBB- in October 2014. The investor base reacted well to the Asciano story and, more broadly, the market is improving its overall support of domestic credits.”

Domestic supportDeal distribution data show strong support for the transaction from

both domestic and offshore investors. Campbell tells KangaNews the final book was more than A$550 million at its peak, although he admits interest tailed off a little when the final spread was tightened.

He continues: “We were ambitiously hoping for a deal of A$200 million plus, so the final A$350 million deal size was a fantastic outcome – and somewhat surprising on the positive side. What was particularly pleasing on this transaction was to be able to deliver a triple-B issuer options for a 10-year deal through the process.”

Wakefield reveals a “pleasantly surprising” domestic take-up of the bonds

“WHEN WE COMPARED THE SPREAD BEING OFFERED ON ASCIANO’S DOMESTIC DEAL AGAINST ITS EXISTING MATURITIES IN US DOLLARS, THE PRICING WAS APPEALING. THE BONDS ALSO OFFERED A THEORETICAL PICKUP VERSUS ASCIANO’S DOMESTIC PEERS.”ADRIAN DAVID MACQUARIE INVESTMENT MANAGEMENT

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given the niche nature of the transaction. She tells KangaNews domestic accounts took 54 per cent, Europe and the UK 32 per cent, Asia 10 per cent and New Zealand 4 per cent. Wakefield adds: “We felt confident there would be high interest from offshore accounts but the domestic portion was particularly pleasing.”

The deal’s lead managers reveal that asset managers bought 82 per cent of the transaction, middle market 8 per cent, banks 7 per cent and private banks 3 per cent. Around 60 accounts participated.

Covenant-liteDemand was also evident in flexibility around terms and conditions. As a global borrower, Asciano sought to replicate its existing structure with its debut domestic offering, explains Peter Block, Sydney-based director, corporate origination at Westpac. As such the transaction did not include financial covenants, which to date has been rare for triple-B issuers in the Australian market. As is typical in Australia, a change-of-control clause was included.

“While there was some quite healthy discussion with investors around these

points the market comprehends a borrower’s need to keep documentation in line across jurisdictions,” Block explains. “This is an internationally competitive transaction and those investors who participated appreciated this.”

Value assessmentsOpinions on pricing vary. One buy-side source insists that Asciano’s domestic transaction was expensive compared with the issuer’s global curve: a fund manager reveals the issuer’s US$250 million 2023 bonds swap back at around 230 basis points over Australian swap – or 15 basis

points wider than the level at which the domestic deal priced.

By contrast, Adrian David, Sydney-based associate director and senior credit analyst at Macquarie Investment Management (Macquarie), says his firm holds a number of Asciano’s US dollar bonds – but the fund manager was entirely comfortable that domestic pricing was appealing.

“It is a good credit story and we found pricing to be attractive,” David tells KangaNews. “When we compared the spread being offered on Asciano’s domestic deal against its existing maturities in US dollars, the pricing was appealing. The bonds also offered a theoretical pickup versus Asciano’s domestic peers, in particular Sydney Airport.”

Wakefield does not believe Asciano’s global bond curve to be the most appropriate comp for a domestic deal. “Our US dollar bonds were issued when Asciano was a very different credit,” she tells KangaNews. “We first visited the US following the company’s recapitalisation, but we have put many runs on the board since then. In addition, the US market is

largely buy-and-hold. Therefore I don’t believe our US dollar bonds offer the most appropriate way to assess Asciano’s value in its current form.”

Leong says pricing was also favourable versus the local market’s most recent 10-year marker. He says: “QM, at triple-B plus, issued a A$200 million transaction at 190 basis points over bank bills. Asciano is rated a notch lower than this, and it is also important to consider the lack of financial covenants in the deal which investors will also have priced in. This was the best funding solution available for Asciano in any market at present.”

Options on the tableThe broad conclusion – by buy side, sell side and intermediaries – is of pleasant surprise at the final outcome. Macquarie’s David, for instance, falls into this camp. Even so, he doesn’t expect to see a large increase in 10-year issuance in the domestic market. “I think the sweet spot in the corporate domestic space remains 5-7 years,” he comments.

Wakefield says Asciano is somewhat overwhelmed by how many investors were even prepared to attend its roadshow. “We were also deeply heartened by the fact that, in most of these meetings, investors were very much behind the transaction’s success. They are clearly supportive of the 10-year part of this market, and all that was missing previously was an issuer that was prepared to open it up. Having forged the path I hope other domestic issuers follow us. It will be a real shame if they don’t.”

Campbell says this latest transaction shows the domestic option can clearly feature in the global funding tool kit. “This deal demonstrates that the domestic market is another funding possibility for issuers that might otherwise have selected

offshore markets – and these issuers are considering their options. I see this as an important new benchmark within the Australian domestic arena.”

Block also believes Asciano’s transaction is market defining, giving other borrowers the necessary confidence to consider Australian dollars for 10-year funding. “We have certainly believed for a period of time that 10 years is achievable for triple-B credits – particularly in the infrastructure and property space. This deal sends a very clear signal that the Australian capital markets are now competitive on a global scale.” •

“WE WERE AMBITIOUSLY HOPING FOR A DEAL OF A$200 MILLION PLUS, SO THE FINAL A$350 MILLION DEAL SIZE WAS A FANTASTIC OUTCOME – AND SOMEWHAT SURPRISING ON THE POSITIVE SIDE. WHAT WAS PARTICULARLY PLEASING WAS TO BE ABLE TO DELIVER A TRIPLE-B ISSUER OPTIONS FOR A 10-YEAR DEAL THROUGH THE PROCESS”IAN CAMPBELL CITI

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KangaTrendsKanga

Australian dollar TLB opens new avenue for high yield

Ajoint venture formed by Leighton Holdings (Leighton) and Apollo Global Management (Apollo) priced a A$900

million (US$697.1 million) equivalent TLB financing in May. The deal included the first-ever Australian dollar-denominated TLB tranche to be offered to investors in the local market, with the local currency accounting for roughly half the total volume.

The transaction is for the new entity, which currently goes by the name “LS NewCo”, and carries a BB+/Ba2 rating.The fully underwritten transaction is divided between A$359 million and US$350 million tranches, and a A$100 million five-year revolving credit facility.

The TLB was advised on and arranged by Barclays as “lead left”, with ANZ, Crédit Agricole and Goldman Sachs as additional lead managers.

Until now, Australian issuers seeking Australian dollars from TLBs have had to engage in a swap to do so. This has not prevented companies from issuing there – according to Standard & Poor’s Ratings Services, issuers include Hoyts Corporation and Nine Entertainment.

However, with the currency of issue always having been US dollars it has been hard to connect Australian funds with these deals. But Duncan Connellan, Barclays’ Sydney-based head of loan

capital markets and leveraged finance, Australia, says awareness of latent demand for high-yielding issuance from local institutional investors led the arrangers to include an Australian dollar element.

“More than 80 investors attended the Australian investor meetings in Sydney and Melbourne,” Connellan reveals. “Demand for the Australian dollar tranche came from credit funds, pension funds, superannuation funds and Asian banks. The majority of the accounts in this tranche were domestic.”

He adds that the Australian dollar component of the book was significantly oversubscribed, enabling an increase to A$359 million from A$275 million.

High-yield optionsThe Australian market has traditionally struggled to marshal sub-investment-grade appetite into deal flow. The margin on the Australian dollar tranche of the Leighton-Apollo term loan B offers a clear incentive for participation: it printed at 550 basis points over bank bill swap rate. The US dollar tranche priced at 450 basis points over Libor with a 1 per cent floor.

Phillip Strano, senior portfolio manager at Victorian Funds Management Corporation in Melbourne, believes the transaction offers a good reward for the risk – even with its covenant-lite structure. He tells KangaNews: “With pricing of 550 basis points over bank bills for seven years

there is adequate compensation for the structure. Some issuers try to seek investor flexibility and fine pricing but this was not so in this particular case.”

Anne Moal, Sydney-based senior high-yield analyst at Perpetual Investments, acknowledges that the structure of the transaction means investors take more risk, but argues this risk is minimal. She says: “If you are comfortable with the company – keeping in mind that laws are very favourable for the senior-secured lender in Australia – it can be acceptable.”

Connellan highlights the appeal of the TLB product in the low-yield global environment. “Investors are prepared to consider different ways to find a return, and this extends into the loan market space,” he explains. “There has not been much of this kind of issuance distributed broadly into the institutional market to date, but this transaction proves there is underlying appetite.”

For this reason, he believes the transaction could be the first of many. “This is not a product that fits every set of circumstances or one that works for every borrower – but it is a genuinely different offering for those falling in the sub-investment-grade category,” Connellan argues. “It also represents an alternative choice for borrowers from the five-year, largely bank-driven, leveraged-finance product.”

Moal argues the demand uncovered by the TLB transaction is “surprisingly” strong. She adds: “Hopefully, arrangers will start being confident to include such tranches and replicate the volume of this transaction. Now the window has been opened up for issuers to raise funds directly in Australian dollars others may look to take advantage.”

Strano also believes other market participants are already exploring similar opportunities in the emerging TLB space. “This is a very successful transaction,” he insists. “I expect a rush to drive more deals through the gap that has been opened up.” •

The presence of a substantial local bid for the first Australian dollar denominated term loan B (TLB) facility could open the door to a consistent domestic high-yield market.

“DEMAND FOR THE AUSTRALIAN DOLLAR TRANCHE CAME FROM CREDIT FUNDS, PENSION FUNDS, SUPERANNUATION FUNDS AND ASIAN BANKS. THE MAJORITY OF THE ACCOUNTS IN THIS TRANCHE WERE DOMESTIC.”DUNCAN CONNELLAN BARCLAYS

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Latest attempt to bring wholesale corporate bonds to retail goes live

Its belief is that there is an untapped pool of demand – mainly in the term deposit (TD) allocations of self-managed superannuation funds (SMSFs) – which only eschews the

corporate bond asset class because of access constraints.

Exchange-traded bonds or “XTBs” are the product offered by the Australian Corporate Bond Company (ACBC). An XTB unit is an Australian Securities Exchange (ASX)-listed security providing beneficial exposure to a single corporate bond.

A total of 17 XTBs have commenced trading on the ASX, covering underlying bonds in the 2-5 year maturity range. All these bonds were issued by investment-grade Australian non-financial corporates – 14 names in total – and were initially sold to wholesale investors at least a year ago.

The one-year seasoning requirement is, KangaNews understands, a condition placed on the XTB product by the Australian Securities and Investments Commission in order for the regulator to allow wholesale product to be made available to retail investors, without the usual disclosure documentation required for listed issuance.

Demand claimsACBC believes there is a substantial potential demand pool for corporate bond product in the retail market – despite record low yields. According to Richard Murphy, the company’s Sydney-based chief executive and co-founder, XTBs provide retail investors with an alternative to TDs which enhance yield without a disproportionate increase in risk.

Murphy notes the more than A$700 billion (US$542.2 billion) value of

household deposits in Australia and, more specifically, the fact that 28 per cent – or A$157 billion – of SMSF assets are held in cash according to Australian Taxation Office data from December 2014.

The SMSF investment pool, Murphy insists, is keen for diversification and is “hunting for yield, security and certainty of outcome” from its cash and TD allocations.

With virtually no fixed-income type product available to genuine retail investors in Australia – other than tier-one hybrids, which Murphy argues bear too many similarities to equity – ACBC believes there is a gap in the market for XTBs to fill. The same ATO data suggest SMSF allocations to debt securities make up less than 1 per cent of the total.

ACBC claims to have received positive feedback and significant interest from the brokerage and financial advisory sectors. Although XTBs will not offer distribution fees to intermediaries as they are a secondary-market product, Murphy argues that they will still appeal to wealth-management channels as they add a complementary product to higher-return asset classes.

In effect, by offering a substitute to TDs rather than equity, XTBs offer brokers a product to sell as a complement for TDs rather than a threat to their equity-based income streams.

KangaNews also understands ACBC is positioning itself as a non-competing organisation with the established wholesale market, arguing that it adds demand to the existing pool. Bonds underlying XTB units will be acquired in the secondary market, and the company has identified as its first 17 product offerings bond lines it believes have sufficient liquidity to facilitate a reasonable level of initial demand.

Even if the product proves successful, the company has no ambitions to originate primary product. As well as rolling out new XTBs, however, it could potentially act as a source of reverse enquiry for increases to existing underlying lines – via established dealers – should demand exceed secondary-market availability.

Business modelACBC makes its own income by levying a fee via its market maker – Deutsche Bank – for the creation of XTB units. This fee, which ACBC expects to be the equivalent of roughly 40 basis points, is passed on to end investors and results in the XTB having a marginally lower yield than would be received by a direct wholesale investor in the underlying bond.

The 17 XTBs initially offered had post-fee yields to maturity (YTMs) ranging from 2.6 per cent, for a BHP Billiton Finance October 2017 maturity, to 3.9 per cent, for a Lend Lease May 2020, as of May 12 and according to ACBC data. The same bonds offered YTMs of 3.0 per cent and 4.3 per cent to wholesale investors at the same point.

Murphy believes yields, even at these reduced levels, will still appeal to retail investors. He points out that they remain greater than TD returns, and also claims that a mixed model portfolio of the 17 listed XTBs has outperformed an Australian government bond index by nearly 90 basis points.

ACBC does not anticipate adding to the 17 initial XTBs in the near future, although Murphy says the company is “ready internally for the second and third cabs off the rank” and that it knows which lines it wants to launch next. The second wave of launches is likely to include XTBs based on financial-institution bonds. •

A new product designed to package seasoned wholesale corporate bonds in a way which makes them accessible to retail investors in both regulatory and volume terms launched on May 14. The company behind it is targeting funds trapped in unrewarding deposit pools.