Idea of the Week: Reasons to continue liking bank bonds

HSBC Holdings plc issued the most SGD corporate bonds in 2023, with three SGD issuances (two Tier 2 subordinated bonds and one senior unsecured bond) at a total of SGD 2,275m. Strong economic performances despite the high interest rates continue to drive a need for financing and banks have been seeking diversification of funding sources apart from the traditional consumer deposits.

Ironically, SGD bank bonds have been the target for a flight to safety, albeit the write-down of Credit Suisse (“CS”) Additional Tier 1 (“AT1”) bonds in March. We see a couple of reasons behind this. First, banks typically offer several seniorities of bonds – senior unsecured, senior non-preferred, and Tier 2 subordinated – all ranking above the riskier AT1 bonds that place first in loss absorption. While some senior bonds might be embedded with loss absorption features (depending on the issuer’s country regulations), the risk on senior bonds is significantly lower.

Senior bonds issued by banks mostly hold a bond credit rating of around ‘A’ (depending on the underlying credit rating of the issuer, but most major banks hold relatively strong credit ratings), while the AT1 bonds generally are rated below investment grade. With attractive credit ratings, senior and Tier 2 subordinated bonds continue to be popular, especially amidst a dry season of issuances.

Second, banks continue to reap the rewards of high interest rates. Since the beginning of the rate hikes, most banks have seen rising profitability with stronger net interest income. In Singapore’s context, DBS, OCBC and UOB saw record profits for their annual results in 2022, with DBS still recording greater profitability quarter-on-quarter in 2023.

Given our view that interest rates are likely to remain higher for longer and despite potentially lesser/ smaller rate hikes, we believe banks continue to benefit from profit tailwinds. Most banks expect rates to peak soon and have lower forward-looking provisions on credit losses – benefitting the banks’ loan books. Lastly, profitability during this period has helped with building the banks’ core capital, allowing for improved buffers against losses.

Since the write-down, we have favoured the senior and Tier 2 bonds. The senior unsecured bank bonds have been attractive given the optimistic short-term outlook on banks. Tier 2 subordinated bank bonds offer attractive yields for their credit rating levels and we believe the risk of loss absorption remains much lesser than the AT1 bonds.

While Tier 2 bonds tend to hold a longer maturity period of minimally 10 years – an extended duration – they typically carry a call option that may be exercised five years before it matures. Duration risk is generally minimized given the embedded call option and the reset of coupon rate (usually in reference to the respective benchmark rate plus an initial margin).

We expect most of the Tier 2 bonds to be called back given the issuer’s incentive to redeem and refinance its Tier 2 capital. Under Basel III regulations, Tier 2 securities that are not called back past their call date have to be amortised until the maturity date, reducing the banks’ Tier 2 capital. Banks are therefore incentivized to refinance, so as to sustain their Tier 2 capital levels.

We advise investors to remain cautious of AT1 perpetual bonds, the more commonly known component of Contingent Convertible (“CoCo”) bonds. We would like to highlight two reasons – (1) we feel that investors have yet to adequately price in the risk of loss absorption, and (2) the risk of non-call remains high on perpetual securities given the elevated interest rates and potentially higher for longer interest rates environment.

For (1), the write-down of the CS AT1 bonds had brought the risk of loss absorption to the spotlight and we felt the initial price declines were fair in addressing the actual risk. However, prices on most SGD AT1 issuances have returned to the pricing prior to the event despite this being an ongoing development, where some investors have sought legal avenues to recover the losses. Considering the overall risk on AT1 perpetual bonds, we believe that the current post-write-down pricing seems lacking in compensating investors for the risk that they are undertaking.

(2) Rising interest rates resulted in fewer calls across the perpetual securities, albeit we still do see most major and regional banks redeeming their AT1 perpetuals. The risk of non-calls continues to be high given the increased cost of debt and higher for longer interest rates, which in some cases, it might no longer be economically viable for the bank to redeem and refinance its AT1 perpetual bonds. Investors ought to include the possibility of non-calls should they choose to invest in such perpetuals, and whether such a scenario would remain acceptable within their investment portfolio.

Overall, bank bonds remain relatively attractive but the risk differs amongst its various seniority.  We prefer senior unsecured bonds given the higher seniority and the need for quality amidst an uncertain economic environment. Otherwise, Tier 2 subordinated bonds offer relatively good yield pick-up for minimal additional risk. In the tables below, we have included some of the preferred senior and Tier 2 SGD issuances, ideally for investors looking opportunities to tap into the stable financials sector.

Table 1
SGD Senior Unsecured and Senior Non-Preferred issuances

Table 2
SGD Tier 2 Subordinated issuances

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in ANZ 4.500% 02Dec2032 Corp (SGD), CMZB 5.700% 03May2033 Corp (SGD), BACR 8.300% Perpetual Corp (SGD), HSBC 5.300% 14Mar2033 Corp (SGD), and the analyst who produced this report holds a NIL position in the abovementioned securities.