One of the biggest stories of 2019 has been the rapid development’s of China’s domestic bond market and nowhere has that been more apparent than in its ability to absorb its banks’ capital needs.
In the space of one year, China’s AT1 market has become the largest in the world. In doing so, China has completely overturned expectations that its banks would be forced to issue offshore not only for their current capital requirements but also for the large chunk of the additional funding they will need once China implements Total Loss Absorbing Capital (TLAC) rules for its Globally Systemic Important Banks (G-SIBs).
Dealogic figures show that China’s domestic bond market accounted for all 15 of the world’s largest subordinated capital transactions in 2019 (AT1 and Tier 2).
Chinese institutions also accounted for 50% of the global total in volume terms across all currencies, up from 31.8% in 2018. Over the course of the year, they raised $197 billion compared to $35 billion in the US, which came second.
Deals range from Agricultural Bank of China’s Rmb85 billion ($12.05 billion) perpetual non-call five issue at one end of the scale to Guizhou Xiuwen Rural Commercial Bank’s Rmb100 million Tier 2 deal at the other end.
So far, this growth has resulted in slim picking for international investment banks. The two big 2014 deals they had expected the banks to re-finance offshore were both called and re-financed onshore: Bank of China’s $6.5 billion AT1 deal and ICBC’s $5.7 billion equivalent dollar-, euro- and renminbi-denominated AT1 deal.
As a result, JP Morgan calculates that 2019 closes with Asian AT1 outstandings of $46 billion, down from $53 billion at the market’s peak. This is not what anyone had predicted at the beginning of the year.
The domestic market’s ability to absorb such paper followed a number of measures the People’s Bank of China (PBoC) instituted during 2019. These included: allowing primary dealers to swap perpetual bonds issued by qualified banks for central bank bills; allowing bonds rated double-A and above as qualified collateral for its MLF/TMLF/SLF/re-lending facilities; and allowing insurance companies to buy qualified banks’ capital instruments, creating a whole new investor base.
Prospective borrowers are also well aware that it is much cheaper to issue onshore than offshore. As one banker commented, “it can be more than 100 basis points cheaper for AT1 paper and that’s even before the cost of swapping the proceeds back into RMB are taken into consideration.”
Then there are the nuances of investor demand to think about. For even though there is a very strong private banking bid for offshore bank capital paper, Chinese borrowers still have to contend with a geographically wider institutional investor base that compares them to much higher-yielding European comparables and does not see any value.
Investment bankers and some analysts, however, are much more positive about the prospects for 2020, although they expect onshore issuance to continue to exceed offshore and some, like UBS, expect AT1 issuance to continue trending lower overall.
On the positive side, the big four banks have publicly announced plans to issue bank capital offshore, although none are under any timing pressure to do so.
Conan Tam, co-head of Asia Pacific debt solutions at BofA Securities, says, “They’re likely to issue offshore capital during 2020 but in smaller amounts compared to before. They want to keep all of their financing channels open and they know that the technical backdrop is very strong.”
Sean McNelis, HSBC’s global co-head of Asia Pacific debt capital markets, is also positive. “AT1 and Tier 2 issuance will again be active across the region, mostly due to refinancing,” he commented. “With a low rate environment and a search for yield again prevalent, Asian demand for such instruments is expected to remain strong in 2020.”
Jason Elder, partner at Mayer Brown and based in Hong Kong, also adds that “we do a lot of FIG work and we’re expecting 2020 to be active as banks continue to adjust to new capital requirements and changing regulations.”
Ernst Grabowski, head of Asia Pacific debt syndicate at Morgan Stanley, is particularly optimistic about the prospects for bank capital issuance.
“This was one of my calls for 2019, but I was a bit early on this one,” he stated. This coming year, I’m making the same call again and think issuance will rise particularly compared to historical averages.”
Grabowski thinks that one driver behind increasing issuance will be slower growth. “Banks will either react to a deterioration in asset quality or take pre-emptive action to create a stronger capital buffer,” he said.
Nomura’s credit research analysts back this argument up. “Chinese banks will face a more challenging operating environment in 2020 as economic growth continues to worsen,” they concluded.
This is one aspect about which investors are realising that they need to become a lot more careful after a number of high profile blow-ups during 2019. On the one hand, they have probably been reassured by the way the government has continually stepped in to protect depositors and ensure systemic stability.
In late spring, China Commercial Bank was drafted in to run Baoshang Bank, while a consortium of ICBC, Cinda Asset Management and Great Wall Asset Management took a stake in Bank of Jinzhou a few months later.
The government, however, did not protect bank capital investors. Bank of Jinzhou missed a coupon payment on its $1.5 billion AT1 deal, while Guangdong Nanuye Bank announced that it would not exercise the call option on its Rmb1.5 billion Tier 2 deal. Baoshang Bank also has a coupon payment on a Tier 2 deal that falls due on December 28.
In a recent research report, HSBC’s sovereign and FIG analyst, Devendran Mahendran, wrote that “top-down institutional support in financials is no longer what it used to be and hence we recommend investors align their views with authorities’ view on defaults”. He suggests that “investors should not chase high-beta performance in 2020, but pick quality credits with an eye on liquidity and allowing for some risks by going down the capital structure.”
What does this mean for spread performance? Chinese investors have historically been price takers when it comes to bank capital paper, but spreads have come in strongly. Not much trades above a 5% yield-to-call.
BofA’s Tam believes that spreads will compress further given strong demand and supply technicals. “I think investors have strong interest in the sector given the lack of supply and that will help to drive spreads tighter,” he said.
Morgan Stanley’s Grabowski also notes that “AT1 has performed well and the senior/spread has also narrowed.” But he adds that spreads are still in the range, which private banking will accept and believes that issuance will be well received.
Nomura’s credit analysts also say they have a neutral outlook because while valuations are unexciting, “limited supply should anchor such rich valuations.”
But they highlight that small bank AT1s now trade about 200bp to 300bp outside large bank AT1s, which they “view as rich considering small banks’ greater fundamental pressure”.
Market participants expected China to firm up its TLAC rules in 2019, but details are still not yet forthcoming. The government says that it has not yet hit the ratio of 55% credit bonds to GDP, which would trigger an acceleration of the process.
Global rules governing G-SIBs currently give the Chinese banks until 2025 to meet their first capital hurdle: 16% of Risk Weighted Assets (RWA) in TLAC instruments.
The sense is that China does not want to implement until it has to and specialists underscore that the capital adequacy ratios of the big banks are much stronger than they were three to four years ago.
Most specialists do not think there will be any TLAC issuance in 2020 or possibly even in 2021. They also think that China may well decide to shun the French model – senior non-preferred or Tier 3 debt – in favour of following Australia’s lead.
As ANZ’s credit strategist Owen Gallimore points out, the Australian Prudential Regulatory Authority (APRA) has allowed Australian banks to use any existing capital instrument to boost their ratios but expects most to opt for Tier 2 capital. APRA expects this to result in a jump in Tier 2 ratios from 6% to 11%, resulting in a 5bp hike on banks’ cost of funding.
Some specialists believe that this route makes sense. “The Chinese government has been quite impressed with what the Australians have done and it would work in China where the banks don’t operate holding company structures and there is no resolution regime to impose losses.”
When the government does decide what to do, Moody’s expects that “it will also require other large banks to hold some form of loss-absorbing debt given China's comprehensive approach to D-SIBs in safeguarding financial stability.
The rating agency recently estimated that China G-SIBs would have an Rmb3.3 trillion TLAC requirement if the rules were to take effect now. It is a massive amount even for China’s own capacious bond market.
Tim Fang, head of global markets at AMTD, believes that the banks will need to go offshore to raise some TLAC debt given the huge amounts involved.
“The reality is that they’ll need and want to tap every market they can,” he said. “I think it’s highly likely they’ll issue onshore first, although it’s always possible they might decide to go offshore first to show what a tight benchmark they can set. But over the longer-term, the majority of TLAC debt will be raised onshore.”
Across the border in Hong Kong, most of the banks are governed by jurisdictions elsewhere: Bank of China Hong Kong by China, while HSBC and Standard Chartered fall under UK regulations.
They seem likely to raise TLAC debt via their parents. HSBC’s McNelis says: “During 2019 we saw further clarity on the Hong Kong and Australia LAC rules. Banks have started to issue to meet the requirements, and we expect further supply in this sector in 2020”
“In Hong Kong, while subsidiaries of G-SIBs will likely issue LAC internally to their parent, we expect other banks with asset bases greater than a certain size will need to look at external LAC issuance.”
The most obvious candidate is Bank of East Asia given that it has already changed its MTN programme to encompass senior non-preferred debt. Bank capital specialists say that the bank has a $6 billion funding need and also has a $650 million 5.5% AT1 deal that becomes callable in December 2020.
Other Greater China banks with callable AT1 deals in 2020 include Bocom with a $2.45 billion 5% deal callable in July, plus China Construction Bank whose 4.65% deal is callable in December. Which way will they go: onshore or offshore?