Idea of the Week: Bank of East Asia- Well-capitalized with Improving Asset Quality

Profitability Saw an Improvement, but Credit Impairment Weighs On Net Profit

Diving into non-interest segments, the weak market sentiment resulted in a 4.1% decline in net fee and commission income and a 24.1% decline in trading and related income. Taken together, non-interest income decreased by 13.3% to HKD 3.9 billion. As a traditional commercial bank, over 80% revenue of BEA comes from interest income, amidst the higher interest income, the bank’s full-year revenue was around HKD 20.8 billion, up 15.6% YoY. The profit before impairment loss surged by 29.6% to HKD 11.3 billion, which is a pretty good quality of earnings.

However, investors may note that the company's profit attributable to shareholders in 2023 fell by 6.8%, which seems to be out of line with the good operational results. The key reason behind this is due to credit impairment losses of HKD 6.2 billion in 2023, an increase of 5% from one year ago, and the loss amount lies at an all-time high. Credit impairment means that a bank's loans are uncollectible because of bad debt (please refer to the asset quality section below for more details). 

NPL Ratio Rose Mildly, Reducing Exposure to CRE Will Be Helpful in Improvement of Asset Quality

In terms of asset quality (Table 2), BEA's non-performing loans surged by 61% to HKD 8.1 billion in 2023, and the NPL ratio also rose by 0.5 percentage points to 1.5%, while both bad debt and bad debt ratio went up to varying degrees, reflecting a weaker asset quality. We see that BEA lowered its provision for bad debt whilst bad debt expanded, resulting in a provision coverage ratio of 35.8%, a 15 percentage points drop from the previous year, indicating that BEA's impairment provision is not adequate. We thus believe BEA is motivated to increase the impairment provision moving forward, which may lead to a significant reduction in net profit.

Table 2: Asset Quality of BEA

If we look at the geographical breakdown of NPL (Table 3), China is the major drag on BEA's asset quality, with the NPL ratio and bad debt ratio reaching 3.1% and 4.9%, respectively, much higher than those in Hong Kong and other regions. The reasons behind this are not new to us, as BEA has much exposure to China real estate, with over 10% of its loans lent to Chinese property developers at its peak (Chart 1), and BEA's asset quality is somewhat weighted by the default crisis of property developers. It is noteworthy that the proportion of BEA's lending to Chinese property developers dropped to 7.1% ending 31 December 2023.

On the other hand, BEA’s NPL ratio and bad debt ratio unexpectedly increased in 2023, which looks to be contrary to the company's lower exposure to Chinese Real Estate. Our view regarding this is that some property development loans have longer tenors and were even lent out to defaulted Chinese property developers before the market downturn, and the credit risk exposure has not yet been fully realized, which is somewhat lagging behind the adjustment of loan origination. Overall, we believe the BEA’s asset quality will improve, and the NPL ratio and bad debt ratio trend downward following the lower exposure to the Chinese property sector.

Table 3: BEA’s Bad Debt Breakdown by Geography 

Chart 1: BEA’s Loans to Chinese Property Sector

BEA is Well Capitalized with Multiple Credit Indicators Among the Best in the Industry

As of December 2023, BEA’s CET1 ratio stood at 17.3%, about 0.5 percentage points increase from June 2023, one of the highest levels in the industry and well above the regulatory requirement. The decent capital adequacy reflects a very robust ability to withstand risk. Considering BEA's announcement of a new budget of HKD 500 million share buyback and the potential redemption of AT1 (see analysis below), the CET1 ratio might drop a bit this year but is still expected to remain at an excellent level among banks. 

Chart 2: BEA’s Capital Adequacy Looking at other credit metrics, BEA’s TLAC risk-weighted ratio hit 23.3%, about 520 basis points above the regulatory requirement as of 31 December 2023. Meanwhile, the TLAC leverage ratio was 12.4%, also well above the regulatory requirement. Moreover, BEA's Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) were 201.5% and 125.5% respectively, both of which met the regulatory requirement of 100%, representing a solid liquidity profile.

Table 4: BEA’s TLAC Risk-weighted Ratio and Leverage Ratio

Expected a Call of Perpetual in September This Year

We note that BEA’s AT1” BNKEA 5.875% Perpetual Corp (USD)” is heading for its first call date in September this year. If it is not being called, the coupon rate will reset to the prevailing 5-year US treasury yield plus the initial spread of 4.257%. Based on the current yield level, the reset rate is at 8.62%, which is not very high given the current high-interest rate environment. So will BEA call the perpetual?

We believe that the probability of redemption of the perpetual is quite high. On the one hand, based on the track records, BEA redeemed all perpetual bonds on the first call date (Table 5). On the other hand, BNKEA 5.875% Perpetual Corp (USD) is trading at around $100, implying the market's belief that BEA would redeem the bond in September.

Table 5: BEA’s redeemed Perpetual Bonds

Bonds Due in 2027 Looks Attractive

In terms of bond investment, we believe that AT1 bonds are more complex and investors interested in BEA may give priority to non-AT1 bonds. Relevant information is set out below:

Table 6: Bond Investment of BEA

BEA's senior non-preferred bonds have a credit rating of BBB (S&P), while Tier 2 bonds have a credit rating of BBB-, suggesting that the latter carries a relatively higher investment risk. Currently, the yield of Tier 2 bonds is around 0.4% higher than that of senior bonds, which means the risk premium is not that adequate, making Tier 2 bonds unfavorable for investment. Among senior bonds, bonds due in 2027 are yielding around 6.6%, higher than other senior bank bonds. Coupled with BEA's rather good credit quality, we believe they are a good investment choice.

It’s worth mentioning that the coupons of the three senior non-preferred bonds are adjustable, whereby if BEA does not redeem the bonds one year prior to maturity, the coupon for the final year would be reset (Table 7). Based on the figures as of 19 April 2024, the adjusted coupons for three bonds for the final year will be 7.51%, 7.31% and 7.11%, with respective projected net yield to maturity of 6.04%, 6.94% and 7.07% (based on Internal Rate of Return), which are slightly higher than the current net yield to maturity, and investors thus do not have to worry about the impact from coupon adjustment. We also notice that BNKEA 6.625% 13Mar2027 Corp (USD) has a higher projected net yield to maturity than BNKEA 6.750% 15Mar2027 Corp (USD), and investors may consider give priority to the former.

Table 7: Coupon Reset for Senior Non-Preferred Bonds

Corporate Risk

Investors should be mindful of the following risks. Firstly, even though BEA lowered its exposure to the Chinese property sector, default risk might emerge from the sectors other than Chinese property due to slower economic growth, which would further uplift the NPL ratio and weaken the asset quality as a result.

Secondly, all bonds issued by BEA (including senior unsecured) are embedded with the TLAC feature, which may result in a full or partial loss under some situations.

Conclusion

Bank of East Asia (BEA) retained fast-growing net interest income in 2023, while non-interest declined modestly, and profit attributable to shareholders saw a dip due to higher credit impairment loss.

BEA is reducing exposure to Chinese real estate developers, but the results are not as good as we expected. Non-performing Loan (NPL) ratio stood at 2.7%, above the industry average, and there is ample room for improvement in asset quality. CET1 ratio hit 17.3%, which is one of the best levels in the banking system, hinting at a decent capability to withstand risk.

Bonds due in 2027 yield 6.6%, which stands out among bank bonds, making them attractive investment choices.