Big-four funders talk strategy as the season changes
KangaNews and RBC Capital Markets hosted their annual roundtable for heads of funding at Australia’s big-four banks in Melbourne on 13 August. After an almost unprecedented period of benign market conditions, 2018 has posed new challenges and seen execution risk back on the table. The issuers acknowledge the revived headwinds but say they are well-placed to navigate them.
Perrignon Conditions were clearly stronger when we had this discussion last year than they are now, including spreads near record tight levels and a broad base of investors engaged across a range of asset classes. In your minds, what are the most notable changes from an execution perspective?
We are seeing equity markets testing new highs and credit periodically rallying, but it feels like we are at one of those inflection points during which something fairly innocuous can set off markets and unwind a lot of what I’d call ‘goodwill’. That’s a gut-feel call on my part, but I have a sense that a more serious correction is not out of the question.
Investors are more wary about geopolitical concerns and are looking for higher new-issue concessions. They don’t want to invest in a bond and see it widen in the secondary market straight after issuance. This is a change, and I don’t see conditions reverting to what they were in 2015-16.
We are already seeing the majors change their execution strategies in response – for instance both Westpac Banking Corporation (Westpac) and Commonwealth Bank of Australia (CommBank) have issued dual-tranche deals in recent weeks, to minimise execution risk. Westpac and National Australia Bank (NAB) have both issued yen bonds recently, as we seek funding diversity – and we are seeing issuance of securitisation and covered bonds for the same reason.
The market has evolved, but as funders we will evolve along with it. I don’t think execution risk across the programme has materially changed, but it is more in evidence on a market-by-market basis.
Davison Changes in the deal process – around things like deal disclosure – emerged during the period of benign funding conditions when presumably their impact was easily manageable. Are those changes having a greater impact in a more challenging execution environment?
We have seen the domestic investor base shifting in recent years, specifically to a place where new-issue premia are more relevant. Not every deal will go well, but I think we have reached a place where deals are appropriately tranched and where price discovery generates the appropriate size outcome.
Holding position on capital
Funding markets may be experiencing renewed volatility but the Australian banking system is enjoying an unusual period of calm when it comes to capital evolution. There is more to come, but there is also confidence that the heavy lifting is complete.
ZILELI We have all made submissions on the future of risk weights and we are waiting on the outcome. I believe this is going to be rolled up in a forthcoming paper covering the nature of “unquestionably strong” capitalisation. That is due at the end of this year – though it has already been pushed back.
We are also awaiting a discussion paper on total loss-absorbing capacity (TLAC), but again this seems to have been delayed. No doubt this will emerge at some point.
KAU The risk-weight issue is in train, and it will have a flow-on impact on the attractiveness of capital-relief residential mortgage-backed securities. This could potentially be quite an important development.
Perrignon We are witnessing some key structural changes in the market backdrop. Rising US rates, moderation of QE elsewhere in the world and taxation reform are front of mind. How are these embedding themselves in markets and to what extent do they require changes to funding strategy?
I believe G4 central-bank balance sheets alone have contributed something like US$12 trillion to global liquidity. While that won’t to be unwound in one fell swoop – and it can be adjusted if markets weaken significantly – I can’t envisage a scenario in which the unwind won’t have a significant impact on all markets, including credit.
The volume of liquidity in the system has covered up all manner of cracks in the past 3-5 years, and its withdrawal is clearly the largest single challenge facing us.
It’s not just that there are a lot of events that make the market nervous – which there are – but market participants often differ in how they interpret events. It’s more important than ever to stay plugged in to investor sentiment.
Earlier in 2018 we issued senior sterling bonds and US dollar covered bonds, both for the first time in more than three years, to capture pockets of investor demand at attractive pricing.
Davison One specific area where there has been commentary around the retreat of liquidity has been US tax reform taking away funds held offshore by US companies – a component of which was being invested in global credit. How much impact has this had on Australian major-bank deal books?
Losing a group of investors as a result of something like tax reform just adds to the atmosphere of caution we have been discussing. There is still good liquidity to be found if you are careful around timing and execution.
“We would certainly be conscious of increasing our exposure to wholesale markets given renewed volatility. There is a system-wide funding gap, but we are yet to see it flow through to our balance sheets.”
What we are left with is the withdrawal of two larger investors – one that isn’t playing at all and another that is only active in much smaller volume. Some of the smaller corporate accounts are still active. But it’s true that some orders have been lost, and we either have to make this up elsewhere or have smaller order books.
Our experience with corporate investors is the same as NAB’s: there are two big accounts that have largely gone missing, but there is another group – albeit with smaller tickets – that hasn’t changed its behaviour at all.
Overall, we can’t say that everything has been rosy with these tax changes and there has certainly been an incremental impact on demand. I don’t think any of us would say we think liquidity is going to get easier over the next 12-18 months, either. But it’s marginal, and it’s taking us back to a point that’s still better than it was 5-6 years ago.
It’s probably a good time for the Australian banking sector as a whole to be funding around A$110 billion (US$81.4 billion) in term markets annually rather than A$140-150 billion.
Structured issuance suffers at the margin
The Australian majors say covered bonds and securitisation remain an important component of the funding tool kit. Issuance of both has ben subdued of late, though the rationale is not the same for both asset classes.
BISCHOFF The original concept of covered bonds was as a triple-A contingent funding tool. If the next 12-18 months features more volatility and significant periods of spread widening, having a triple-A instrument available should allow access to certain offshore markets when senior is volatile.
If these conditions don’t eventuate we will likely continue to focus our covered-bond issuance on duration and investor diversity in core markets.
ROBB The double counting of covered bonds under the bank levy detracts from the relative economics and the asset class gets unfavourable net stable-funding ratio (NSFR) treatment.
Davison Putting aside credit growth, is that number – roughly A$110 billion – the baseline for total big-four funding expectations going forward? Presumably duration extension reduces refinancing velocity.
As you say, a core driver of tenor extension is reducing refinancing risk. Given the macro environment we’ve discussed, I don’t think any of us would want to face the sort of term-funding requirement we navigated a few years ago.
The reduction in term-funding requirement makes it possible to be well supported by the pockets of demand we’ve found and not to need every single investor to be active.
Conversely, when the Australian dollar is weak – certainly if it was close to US$0.60 – we would have to do a lot less offshore funding because what we issue would be returning more Australian dollars. This is a really good ‘right-way risk’ for the system.
Davison There have been several references to the value of funding diversity. Does this mean the banks are, at the margin, more willing to pay a premium for currency and asset-class diversity or is diversity coming because the economics of a wider range of issuance options have improved?
There’s no single driver, but if one or more markets are offering clearly better value it’s pretty difficult, in the context of a smaller funding programme, to justify issuing elsewhere. We hadn’t issued in the yen market for two or three years, for instance, purely because the basis swap had made it uncompetitive.
When we issued €500 million (US$579 million) of floating-rate notes in May we saw a very different investor book from our typical fixed-rate euro deals. But we decided to launch as it was an appealing price. The investor diversity was a bonus.
There wasn’t any consideration of a diversity premium for us, because the pricing was there. Actually we would have been more inclined to contemplate a diversity premium in previous years, when the funding task was larger.
Sustainability and blockchain feature in funding innovation
Green and sustainable debt should become even more prominent in the major-bank funding mix, the big four say. This is not the only funding innovation catching the eye, either.
ROBB Commonwealth Bank of Australia has a strong commitment to respond to the challenge of climate change and is active in low-carbon financing to support our transition to zero emissions by 2050. In the sustainable-issuance market, we are focused on a rigorous approach to socially responsible investment asset classification. The transaction we did last year was, at A$650 million (US$481.1 million), the largest green bank deal in Australia and was accredited by Climate Bonds Initiative.
We have communicated to investors that we want a robust, sustainable green asset class. The management task around assets is not inconsiderable as a result. In addition to identifying eligible assets, this involves ongoing monitoring and reporting as well as validating and separately auditing those assets. The feedback we have received, especially from the international investor community, is that this approach has long-term value.
KAU It’s right to describe this as a developing space, and as market participants become more aware of environmental and social concerns it will get bigger both from an asset perspective and on the bond-market inflow side. We will meet the demand from investors, because it naturally makes sense to match the two sides of the balance sheet.
Davison The Australian base rate has continued to trend upwards through 2018. How has this affected funding strategy?
This is due to a number of – sometimes conflicting – reasons, but it’s important to note that these are mainly technical in nature. They certainly do not relate in any way to funding pressure. It’s obvious that we are not experiencing funding pressure, but it’s also a message we are making clear to investors.
Our sense is that the cause is a combination of lots of small things, mainly technical factors, including elevated repo demand and basis swaps.
The impact is not insignificant. I think CommBank’s most recent results said that each 5 basis points of movement in the base rate means 1 basis point of net interest margin. ANZ Banking Group has a smaller household balance sheet so the impact is not as great, but it’s still material.
How the banks deal with this is yet to be seen. But if the movement in the base rate is prolonged they will clearly have to work through it. The environment makes it much more difficult to do so than it would have been five years ago – from both a funding and a political perspective. But it’s absolutely critical to reiterate that this is not an issue of funding pressure and it will not affect how we go about funding.
There is good evidence to support the relevance of international-bank Australian dollar funding requirements and the flow-on impacts to FX and the bank-bill swap rate.
As for the term-funding impact, I agree with Mostyn Kau in saying I don’t think it materially alters the way we think about markets. We haven’t seen investors particularly concerned about this issue, though they are interested and want to understand what’s happening.
“The market has evolved, but as funders we will evolve along with it. I don’t think execution risk across the programme has materially changed, but it is more in evidence on a market-by-market basis.”
Davison Has the protracted nature of the base-rate run-up come as a surprise? Our sense is that a lot of market participants initially thought it would reverse earlier in the year – especially as the initial increase matched a similar move in US Libor that did unwind much sooner.
We’re not talking about a long time, in other words – but there’s no way of knowing for how long it will last. I suspect it will moderate, but that’s not a conclusive view.
Perrignon The national savings rate in Australia has been in decline for some time but we haven’t yet seen this translate into challenged deposit growth. What is banks’ read on deposits?
Perrignon What is investor feedback on the Australian housing market at present? Do investors seem comfortable with macroprudential controls and with the soft landing that so far seems to be developing?
The questions we get asked are about our arrears in particular, and they also tend to match the headlines. This year, for instance, we have had a lot of questions about underwriting and borrower expenses – because there was an article on the topic written by one of the research houses.
In many respects, when we go offshore our job is around education. We’ll explain, for instance, that our approval process doesn’t just accept the income a potential borrower declares and we do look at payslips and deposits, and that we have changed the granularity of the process we use on the expenses side.
Really, what investors are asking is whether what they read is true. They want to see how our practices align with the headlines.
Davison Has the nature of dialogue with investors on housing changed since the introduction of macroprudential measures in the second half of 2016?
In particular, investors are seeing APRA’s removal of the 10 per cent investor-only growth limit as evidence the market has responded as intended.
The Reserve Bank of Australia gave a speech a few months ago about some of the mitigating factors around this debt, but it’s not surprising that offshore investors are interested in the topic given what happened with resetting loans in the US.
We emphasise that the mortgage market in Australia is very different structurally from the US. Where lending standards in the US were loosening at the time, ours are tightening. It’s a very different set of circumstances here too, for instance, than in some European countries – where banks were lending up to 125 per cent loan-to-value ratio – or in the US, where they were lending significant volumes of subprime.
“It’s not just that there are a lot of events that make the market nervous – which there are – but market participants often differ in how they interpret events. It’s more important than ever to stay plugged in to investor sentiment.”
Davison China has traditionally been a focus of offshore investors and it is back in the headlines around global trade. What is the feedback from investors on China at the moment?
My sense is that investors are more comfortable with the way in which China has managed its slowdown and the tools it has available to do so – and therefore also with the impact this has had on Australia.
Having said all this, we haven’t roadshowed since May and it is in the period since that rhetoric around trade has really picked up. Certainly our experience is that global investors have been much more interested in the housing market and the royal commission.
“I think we are facing a much bigger challenge in the next couple of years, because of the sheer volume of liquidity that is going to be drained from the system.”
Davison What are global investors asking about the royal commission?
To be fair, it’s hard for us to give a definitive response to these questions – other than to say, at a very high level, that it would be naïve to assume there will be less regulation in future than there is today. How that will affect credit is unknown at this stage.
investing with impact Yearbook 2017
KangaNews's first-ever supplement focusing on sustainability in the Australian fixed-income market.