China, the world’s second largest economy after the US, is likely to drive a bulk of dollar-denominated Basel III Tier-2 bonds — or new-style bank capital — volume as the country’s local banks look to shore up cheaper forms of funding.
The mainland’s top five banks have obtained approvals last year to issue a combined Rmb270 billion ($43.5 billion) worth of Basel III-compliant bonds from 2014 to 2016. The banks are Agricultural Bank of China, Bank of China, Bank of Communications, China Construction Bank and Industrial and Commercial Bank of China.
While that includes issuance in both onshore and offshore markets, Bank of America Merrill Lynch believes that a quarter of that approved total will be issued in the latter market.
“China is the major X-factor in terms of issuance that may come,” Alan Schmoll, debt capital markets director at BofA Merrill said to FinanceAsia.
China began to enforce Basel III standards on January 1 2013 and there have been two issuances from the country’s local banks so far. ICBC Asia launched a $500 million 10-year Basel III-compliant Tier-2 note last October — Asia’s first ever dollar-denominated new-style bond — while China Citic Bank raised a $300 million 10.5-year offering in November.
There have been no new-style offerings from Chinese banks so far this year, according to Dealogic data.
ABC announced this year that it planned to sell up to Rmb90 billion of new-style Tier-1 and Tier-2 capital before the end of 2015 in onshore or offshore markets. CCB and ICBC also announced similar funding plans for up to Rmb60 billion each, while BoC has yet to reveal its plans but is expected to raise in the tens of billions as well.
“China is a big swing factor and when the issuance of bank capital notes eventuates that would be in the billions of dollars,” said Mark Follett, head of high-grade, Asia ex-Japan at JPMorgan. “Banks are trying to reduce their cost of capital as effectively as they can, and non-dilutive capital like Tier-2 and Additional Tier-1 capital as opposed to common equity is the way to do that.”
Unlike the issuance of Tier-2 or Additional Tier-1 notes, the issuance of new common equity dilutes the ownership percentage of a share of stock. This essentially means that value of existing shares is reduced.
Asia could see an additional issuance of up to $10 billion or more in the remaining months of the year if Chinese banks actively participate, Follett said. Without the mainland banks, he estimates another $3 billion to $5 billion of supply will come from Hong Kong, Korea, Singapore and Thailand.
Indian financial institutions, which have been actively raising bank capital domestically, could also be potential Basel III-compliant capital candidates in the international market.
Asia-Pacific dollar-denominated Basel III Tier-2 bond volume has reached $8.7 billion with nine deals year-to-date, according to Dealogic data.
Basel III Tier-2 evolution
Unlike Basel II Tier-2 notes — also known as old-style bank capital — the new-style bonds come with a “non-viability loss absorption” clause and the terms can vary from jurisdiction to jurisdiction.
The non-viability loss absorption clause is where investors could lose all their money if regulators decide that a bank cannot survive. This can happen in two ways: there can be a write-down of the notes’ principal or a conversion of that paper into equity.
In the region, the most investor-friendly of the various non-viability clauses come from Japan and Korea. Their governments are allowed to make pre-emptive capital injections into the respective financial institutions before creditors absorb the losses, bankers said.
Such resolution frameworks aim to minimise any disruption to the financial system. This is seen as the lowest cost resolution method and, as a result, is viewed positively by investors.
This is completely different from ICBC Asia’s non-viability language, where an injection of funds by the Hong Kong Monetary Authority would make the financial institution non-viable. In such a scenario, the bond will be written down to zero.
“ICBC Asia’s non-viability language, which strictly followed Basel III guidelines, has been picked up by the market and ever since then there have been some variations around that,” BofA Merrill’s Schmoll said. “The variations have tended to be more investor-friendly ever since.”
Also in terms of pricing, the spreads of new issue premium of the Basel III-compliant Tier-2 notes have narrowed since ICBC Asia came to market last October. This is because issuers and investors alike have discovered that these new-style notes are no more onerous than the old-style in substance, experts said.
“In form, they obviously carry features that appear a lot riskier to the market due to the non-viability clause, but in substance they are not that different,” said JPMorgan’s Follett. “So we argue that the premium between the old- and new-style should not be excessive.”
When the first deals came to market, the new issue premiums were as wide as 80bp. Currently the average is around 30bp, although premiums as tight as 10bp were seen from Korean issuers, such as Woori Bank’s recent Basel III Tier 2 note in April.
“The narrow spread for Korean banks reflects the comfort level that investors have with regards to the regulatory regime in Korea,” Follett added. “But it has been satisfying to see the premium has come down in the past six months.”
