ANZ's Subordinated Note offer

The race is on. After several income security issues late last year, companies seeking capital have learned where to find it.

In the past week alone, Tabcorp, Colonial Group (review due very shortly) and now ANZ have announced subordinated note offers. Westpac is issuing preference shares, which we’ll also review this week.

Borrowers know that investor demand is limited. Perhaps sensing a growing ambivalence on the part of investors, ANZ Subordinated Notes is a clearly superior offer to the CPS3 issue rejected last September. But does it warrant a Subscribe recommendation?

There’s a crucial issue in this sector, explained briefly in Comm Bank: Boom ends quietly for now on 17 Feb 12 (Hold - $50.21) and identified years ago in Our big banks’ Achilles’ heel. Our banks require foreign capital—lots of it.

Should that money dry up because overseas lenders lose faith in our banking system or simply run out of money themselves—as is happening to European lenders—the banks will need to pay more for capital. They’ll also charge more for it. The difference between overnight rates, set by the RBA, and mortgage rates is already growing for this very reason.

With a recent tightening in funding markets, banks are keen to diversify their funding sources away from skittish international sources and lock in long-term capital at reasonable prices. That’s why three of the big four banks have announced new issues.

Subordinated Notes vs CPS3

ANZ is looking to raise $500m through this offering, with the ability (and desire) to raise more. Table 1 shows how it outshines CPS3. The subordinated notes are a form of debt, not a preference share. In an insolvency situation, the notes stand ahead of ordinary shareholders and preference shareholders, although behind depositors and bondholders.

Noteholders receive cash distributions equivalent to the three-month Bank Bill Rate plus a margin of between 2.75% and 3.0%, set in a bookbuild today. The notes must be repaid with cash, not ANZ shares.

Distributions are compulsory except where a distribution payment would push ANZ into insolvency, in which case the payment won’t be made. That differs from the CPS3 distributions that are subject to the absolute discretion of the ANZ board and the Australian Prudential Regulation Authority (APRA) and are non-cumulative if a payment is skipped. The ANZ Notes are clearly a safer security than CPS3.

But is the compensation of a 2.75-3.0% margin over the bank bill rate adequate compensation for the risks involved?

Dramatic change

After a dramatic change to Australia’s banking laws to allow the issuance of covered bonds (a matter we’ll expand on another time), ANZ issued US$1.25bn of covered bonds late last year at a margin of 1.15% over the benchmark rate. Other big banks quickly followed, issuing bonds at similar margins.

These wholesale bonds aren’t available to the retail proletariat. But understand that, from an investor’s point of view, covered bonds are the safest possible bank debt instrument—in addition to the promises of the bank, they’re also backed by an individual pool of assets (generally home loans). In effect, this means they rank above even depositors in the capital structure.

If 115 basis points is an appropriate margin for a very safe, five-year covered bond, 275 to 300 basis points on a subordinated note—riskier and, with a likely maturity in 2022, longer-term—seems paltry.

Table 1 also stacks the two ANZ securities against the CommBank Retail bonds (ASX code CBAHA) issued in 2010 and available on the market today at $97.50.

It makes the point that the CommBank Retail Bonds are safer again than ANZ Notes, ranking higher in the case of insolvency and with distributions that, if skipped, would force the bank into insolvency—pure Valium for bondholders.

CommBank Retail Bonds might offer a lower yield to maturity than the ANZ Notes but not drastically so. As a safer security with a shorter duration, the difference looks slim, even though the CommBank Bonds are no bargain.

Heating up

The competition for your capital is heating up. That could be reflected in the margins of future income security offers, in the price of already-listed instruments and also in valid alternatives such as bank term deposits. There’s no point jumping in to an offer like this when better ones already exist and more are likely.

Australian banks need to raise more capital. When investors arrive at the same realisation, better deals than the one detailed in this prospectus are likely to emerge. The fact that ANZ is our least favoured big bank by dint of its risky Asian expansion strategy only adds to the argument for tossing the ANZ Notes prospectus in the bin.

This isn’t the worst deal around—both the Tabcorp and Colonial offerings are worse. If you can’t resist it, bear in mind our suggested maximum portfolio exposure to the banks of 10%. Treat any investment in ANZ Subordinated Notes as a part of it.

But our recommendation is to AVOID this offer and wait for a fatter pitch. We suspect it’s coming.