ASX hybrids appear expensive post proposed APRA change

Last Tuesday, APRA released the second phase of its consultation paper on the ASX hybrid market (AT1), proposing significant changes to the structure of bank capital stacks. 

The key proposal is to phase out AT1 as a component of bank capital. For large banks, the existing 1.5% AT1 requirement would be replaced by 1.25% Tier 2 capital and 0.25% Common Equity Tier 1 (CET1) capital. Smaller banks would replace AT1 entirely with Tier 2 capital.

If implemented, this transition would begin in January 2027 and continue until 2032. During this period, upcoming AT1 calls would be refinanced with Tier 2 capital as they mature. Given the current Tier 2 requirement of 6.5%, the additional 1.25% would represent approximately a 20% increase in the size of the Tier 2 market by the end of the phase-out period.

This proposal aims to strengthen the resilience of the banking sector by adjusting the composition of capital requirements. 

APRA Chair Jon Lonsdale stated, “Replacing AT1 with more reliable forms of capital will enable banks to more quickly and confidently use their capital buffers in a crisis scenario and is expected to reduce compliance costs for banks. It will also strengthen the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks compared to the new requirements for large banks.”

Market reaction

AT1 spreads have tightened (19 basis points) while Tier 2 bonds have slightly widened (2 basis points) month-to-date. The yield differential between instruments has decreased to 30 basis points (including franking) at 3 years time to next call, the lowest since February 2023. 

Additionally, AT1 spreads are at their lowest since the global financial crisis and nearing 2007 levels. The movement suggests the market may have misinterpreted APRA’s proposal that AT1 will be treated similarly in policy terms to Tier 2 bonds. Consequently, this potentially poses a risk for AT1 investors for several reasons.

AT1s should continue to command a yield premium over Tier 2 instruments: While AT1s become eligible for Tier 2 treatment from a bank capital perspective during the transition period, the proposal does not suggest that existing policy terms cease. AT1s will still be treated in accordance with a ‘going concern’ stress event and Tier 2 in a ‘gone concern’ event. Additionally, there is a two-year-plus period before the transition period initiates. The tight AT1 spreads suggest that they appear expensive.

Sufficient market capacity to absorb additional Tier 2 issuance: APRA increased the Tier 2 capital requirement buffer for Australia’s big four banks in 2019 and 2021. Specifically, the Tier 2 target was raised to 6.5% of risk-weighted assets (RWA), effective 1 January 2026. Consequently, the Tier 2 market has expanded significantly, reaching $125 billion in recent years. With the majority of the big four banks achieving the 6.5% target, it suggests that there will be limited additional net new issuance going forward.

APRA’s proposal mandates that AT1 calls, amounting to $40 billion outstanding, be refinanced as Tier 2 capital. Projecting the upcoming calls for AT1s and Tier 2 bonds indicates that the total issuance will be lower than the total Tier 2 issuance observed in recent years. This suggests there is adequate market demand to comfortably absorb the supply. 

Additionally, despite the rapid increase in Tier 2 market size, credit spreads have steadily declined since July 2022.

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