Oh dear. Covered bonds have been rushed out by regulators with unseemly haste – in what Deep T. considers the biggest structural change to Australian banking in thirty years – and the banks, led by Westpac and ANZ, have also rushed to market. And the result? Not good. From Phil Bayley at Banking Day:
The headline pricing for the two covered bonds was the same, at 115 basis points over US Treasury mid-swaps. ANZ sold US$1.25 billion in bonds and Westpac US$1.0 billion.
In the case of ANZ, this is understood to have swapped back to Australian dollars at 150 bps over bank bills. Westpac’s swapped-back cost should be similar.
The rule of thumb for comparison with unsecured corporate bond spreads is that the credit spread paid on the covered bonds should be half to two-thirds that paid on unsecured bonds.
Using a conservative ratio of two-thirds as the measure for comparing covered bonds with orthodox wholesale bank borrowing, this suggests a spread on unsecured bonds for funds raised in offshore markets of 225 bps for ANZ and Westpac.
CBA was the last of the major banks to issue five-year bonds in the domestic market. It raised A$2.5 billion in July at a spread of 117 bps over bank bills.
In other words, covered bonds are now costing what unsecured borrowing cost just four months ago. Bear in mind, too, that during the GFC, government guaranteed “unsecured debt” was being issued at 190bps (including the government fee). That gives you some idea of just how expensive wholesale markets are for Australian banks now.
And things are no better for the CBA, which has pulled (it’s been “held up”) its inaugural covered bond issue in Europe. According to the AFR, CBA was faced with paying 175bps over the bank bill rate (including, presumably, swapping into $A).
This is pretty extraordinary and has some big implications. Firstly, we have to ask exactly what has the rush to covered bonds achieved? Phil Bayley suggests that the desperation of the banks has meant that investors saw ANZ and Westpac coming. He asks: “Why did the banks clearly flag to investors that they were all coming to the market at the same time, each with initial bond issues of US$1.0 billion plus?”
Obviously some of the extended pricing is the result of the European crisis as well. But, I refer back to Deep T.’s analysis of last week in which he argued that covered bonds simply shuffle the cards. By carving off a tranche of the banks best assets to secure the covered bonds, you inevitably raise the risk on the remaining unsecured bonds and their price goes up, dragging up the price of the covered bonds anyway.
Beyond that, if funding markets deteriorate much further, covered bonds are going to become uneconomic for the banks (they already are for CBA apparently) and we, the tax payer, will have to step in and guarantee them as well!
And it doesn’t stop there. Yes, the banks are carrying nice big sacks of liquid assets, but how long before this pricing pressure starts to materially inhibit profits and therefore equity values? That means higher interest rates for customers shortly or, perhaps, the need for a bigger spread to avoid those hikes. That is, a rate cut that isn’t passed on to customers. You can’t, of course, cut rates 25bps and expect the banks to keep it all. So that raises the prospect of a 50bps cut in the not too distant future.
The RBA’s December meeting is getting more interesting.
