The margin differential between tier 2 securities and additional tier 1 securities (hybrids) has become “abnormally narrow” and may stay that way for some time, according to new research.
At the end of last month, Suncorp Group completed a A$290 million issue of wholesale subordinated notes, tier 2 securities, priced at a margin of 230 basis points over the three-month bank bill swap rate. The notes have a term of 15.2 years and Suncorp has the option of redeeming them in June 2027 and each interest payment date after that.
Fixed income researcher BondAdviser said that if Suncorp had issued three months earlier its margin would have been under 200 bps. Inflationary pressures have become more pronounced over that period and the Ukraine war has added more uncertainty.
BondAdviser said that while tier 2 margins widened during the March quarter, margins on tier 1 listed securities (hybrids) tightened.
It said Suncorp Group Capital Notes 3 (SUNPH), which were issued in 2019, provide the closest comparison with the subordinated notes in terms of maturity. While the margin on the subordinated notes is 230 bps, the margin on SUNPH (extrapolated to match a five-year call) is 263 bps.
This represents a 33 bps premium for additional tier 1 listed securities. Over the past seven years, this premium for all issuers has averaged 158 bps.
“A key reason for the contraction is the vastly more sensitive wholesale investor market for tier 2 securities,” BondAdviser said.
“In the hybrid market investors are much more comfortable holding their investments to the call date without the need to mark to market.
“The threat of rate rises doesn’t generally bother investors in the hybrid market. Hybrids are floating rate instruments and so rate risk is not a major consideration.”
It said this abnormality may persist for some time. Revised ADI capital requirements are expected to be resolved by the issuance to tier 2 securities. This will increase supply relative to hybrids and be a “margin expanding input for tier 2 performance.”
In addition, the way hybrids are sold has changed as a result of the start of the Design and Distribution Obligation and this is putting downward pressure on hybrid margins.
BondAdviser said it expects to see continued weakness in tier 2 margins over the medium terms and the current margin differential to continue for some time.