Index inclusion could be another tier-two tailwind

The proposals are part of a wider move to implement changes across Bloomberg’s Ausbond universe that would bring a level of consistency with its global offerings. Buy-side sources confirm that the most relevant aspect for Australian dollar investors would be the inclusion of nonviability bonds – in particular bank tier-two securities.

Bloomberg was contacted for comment.

KangaNews understands most actively traded tier-two instruments are being considered with no restrictions on tenor or issuer origin – meaning Kangaroo deals would likely be included. Bonds with deferable coupons or tranche sizes less than A$100 million will not be included.

The potential for tier-two index inclusion has been known to investors for some months but market participants say it is difficult to determine whether pre-positioning has had any impact on spreads. One source cites the softer tone in markets since the latter half of February and early March, and multiple cross-currents affecting Australian dollar credit market dynamics.

Overall, this source notes it has been an “incredibly strong start to the year, with spread compression evident across most components in the market”. Heavily oversubscribed new-issue orderbooks suggest some active managers may have been seeking to get ahead of the final decision on index inclusion, but there have also been technical dynamics driving tier-two more broadly – including interest from Asia and the phase out of AT1.

Market participants expect inclusion to provide an additional demand tailwind for an asset class that has already become a growth hotspot in the Australian market. In this case, passive investment mandates benchmarked to the AusBond indices will likely expand their universes beyond senior paper and into tier-two.

For instance, Gavin Goodhand, Sydney-based senior portfolio manager and co-founder of Altius Asset Management, tells KangaNews: “We have generally seen liquidity in this segment grow over the last two years, but this change would bring an additional level of demand to the market. With the inclusion of different types of assets, index players – domestically and abroad – will start to participate more. There is a chance that that will bring additional liquidity, which is a positive.”

The potential index changes come during a period of significant growth for the Australian exchange-traded fund (ETF) industry. According to the ASX, assets under management in Australian fixed income ETFs has doubled since 2021 to reach A$28 billion in 2024.

Dylan Bourke, managing director and portfolio manager at Kapstream Capital in Sydney, argues that the greatest impact of an index update would be in the passive segment. “Tier-two index inclusion would likely lead to a new buyer base in passive fund managers, providing additional tier-two liquidity and volatility insulation during softer trading conditions,” he suggests.

But this also implies the potential for index inclusion further to encourage participation from active asset managers and absolute return mandates. A broader buyer base that begets increased liquidity should only increase confidence in the tier-two asset class across investor types.

Indeed, some sources believe index inclusion should provide some insulation to tier-two securities during tougher market conditions. There are trade-offs, however. One market source says the Australian Prudential Regulation Authority’s plans to scrap the additional tier-one asset class will make tier-two an inherently riskier level of the capital stack.

The same source also asks whether it is appropriate for higher beta, regulatory capital instruments to reside in the same benchmarks as traditional, defensive fixed-income securities. In this context, questions remain about how conversion would be treated in the indices and whether increased holdings of capital notes would effectively require funds to divest at least some of their holdings of bank equity.

Investors that view fixed income as a defensive asset class may not welcome the inclusion of tier-two in the AusBond Composite Index. Commonwealth government and semi-government securities make up 80 per cent of this index, and other high-grade issuers – including global supranational, sovereign and agency names – contribute significantly to the balance. This is clearly a defensive benchmark, in other words.

By contrast, George Bishay, head of credit and sustainable strategies at Pendal Group in Sydney, tells KangaNews: “End bond clients want an asset class that generally performs when equities sell off. Subordinated bank debt is at the high-beta end of credit spread movements and these securities tend to underperform all other investment-grade asset classes when there is an equity market downturn.”

Therefore, Bishay explains, a cohort of Pendal’s end clients are averse to the firm investing in subordinated debt – instead opting for bonds that are liquid and defensive through the cycle. “Liquidity in subordinated bank debt can be very flaky at times relative to other credits,” he continues. “It has improved over the years given how much volume is being issued, but liquidity can still evaporate quickly – and much quicker than for senior paper.”

Bishay also says Pendal’s insurance clients take account of final maturities rather than first call dates on bank subordinated debt in the context of risk charge, for which insurance accounts need to be compensated. “The final maturity is far more expensive and we therefore have clients that naturally will not have an interest,” he explains.

By contrast, Goodhand says he is comfortable with tier-two product in the composite index, noting the presence of triple-B rated corporates in the indices, which could be considered high beta as well. “We aren’t benchmarked to the FRN [floating-rate note] indices but full inclusion of tier-two in the composite index would only amount to 1.5 per cent weighting," he highlights.

“If credit markets are under pressure, tier-two will underperform. But the same thing can apply to a traditional corporate – I don’t consider risks in the subordinated space to be too dissimilar to other sectors."

In general, investors are quick to note that index inclusion is not a panacea for all potential market challenges, and that generally speaking during a market downturn behavior amongst investors will be the same. 

“Inclusion in the index means there is always a natural buyer – but liquidity can be a bit of an illusion,” says Goodhand. “When markets are under pressure, investors tend to sit on the sidelines. Inclusion would act as more of a soft underpinning.”

Other unknowns also remain. For instance, it is not yet clear whether there will be retrospective inclusion of product or just securities issued in future, says Goodhand. Inclusion of tier-two debt in credit indices could translate to a 12 per cent holding in index-tracking portfolios – which represents a significant rebalancing task.

“If a fund manager is benchmarked to this index but doesn’t want to be underweight, they will be seeking the allocation before it comes into the index,” Goodhand says. “There are inherent risks here.”

KangaNews understands that one avenue Bloomberg is exploring is a dual-track approach with two types of indices: the traditional composite index and one that includes tier-two. The same approach could apply to the FRN benchmark.