A new style of tier two subordinated debt

Heritage Bank (rated BBB+) issued a new style of Basel III compliant, tier two subordinated debt to institutional investors last week, and in the process has likely set a benchmark for differentiated pricing of such securities.



The bank sold A$50 million of ten-year, non-call-five subordinated notes, priced at a margin of 350 basis points over bank bills. At first glance the margin seems unremarkable but this is tier two capital, not additional tier one capital.



Recent additional tier one capital issues in the wholesale market have priced at 400 bps-plus.



However, if the pricing of the Heritage subordinated debt is compared with the closest comparable issue in the market, the difference is stark.



The closest comparable issue is ME Bank's A$300 million of tier two notes sold in August last year. The notes with the same ten-year, non-call-five maturity structure, were priced at 270 bps over bank bills at issue, and now trade around 240 bps over.



The ME Bank tier two notes are the closest comparable to the Heritage Bank notes not because the credit ratings of the banks are the same but because the ME Bank notes do not convert into ordinary equity in the event of non-viability being declared by the Australian Prudential Regulation Authority.



This is a significant difference from all the other tier two capital issues outstanding, where conversion will be into the ordinary shares of the issuer, with existing shareholders diluted accordingly. The ME Bank issue was priced wider as a result.

Investors in the ME Bank tier two notes will have their notes converted into unlisted, non-voting ordinary equity. There will be no effective dilution of ME Bank's industry superfund shareholders.



Thus, conversion of the tier two notes will have no adverse impact on ME Bank's shareholders at all. In fact, it could be a benefit from the point of view that a A$270 million debt obligation is wiped-out.



The shareholders of ME Bank have no incentive to avoid the conversion of its tier two capital, except perhaps allowing for the possibility that future dividend payments, if there are any after a non-viability event, may have to be shared with the new non-voting shareholders.



The new Heritage Bank issue goes a step further in eliminating incentives for shareholders or owners to avoid non-viability, and this explains the wider pricing seen. The tier two capital issued by Heritage Bank will simply be written off, if APRA declares non-viability.



Heritage Bank is a mutual bank and is therefore owned by its depositors. There are no shareholders and there is no share capital.



Nevertheless, APRA released a prudential standard, APS 111, in April last year, that allows for the creation of mutual equity interests in just this situation. But the mechanics of allowing for the creation of mutual equity interests at the point of non-viability are cumbersome, and the prospect of holding an illiquid investment in an entity that does not pay dividends is unattractive anyway.

With this in mind debt holders may well prefer to have their debt written off and at least have a capital loss that they might be able offset against any taxable capital gains. But this raises another question that we will come to in a moment.



Under the Basel III capital adequacy provisions conversion or write-off of additional tier one and tier two capital when required, is permitted because both treatments have the benefit of increasing equity and reducing liabilities. However, in Australia it had been thought that exercising the write-off option would result in the realisation of a fully taxable capital gain, which would most likely be counterproductive, particularly at the point of non-viability.



For this reason APRA had stipulated that, if the write-off option was used, it would only count 70 per cent of the funds raised as additional tier one or tier two capital.

Heritage Bank has avoided this problem by obtaining a private ruling from the Australian Taxation Office to the effect that any write-off will not be taxable and has persuaded APRA to accept this position, according to a report published by KangaNews last week.



Heritage Bank has set a precedent and no doubt more tier two capital issues with a write-off provision will be seen. We may even see the provision appear in additional tier one capital issues - this will be something that retail investors, in particular, will need to look out for.



Heritage Bank has had to pay a price to issue its tier two capital with a write-off provision. But have debt investors considered that if write-off of the debt does not result in a capital gain for the bank, it is likely that it will not result in a capital loss for them?



Additional tier one and tier two capital issues should rightly be priced at levels wider than issues that allow for equity conversion. The risks to noteholders are just that much greater again.