Research Report
Key Characteristics
Issuer Name
Westpac Banking
Corporation
Product Type
Capital Note
Last Price
$100.00
Issue Size*
$750,000,000
Accrued
-
Par Value
$100.00
Capital Price
$100.00
Fixed/Floating
Floating
Running Yield**
6.15%
Payment
Frequency
Quarterly
Yield to
Maturity***
6.70%
Security Recommendation
Current
Distribution**
6.15%
Trading Margin
-
Subscribe
Issue Margin/
Coupon**
[4.00 - 4.20%]
Optional
Conversion Date
22 March
2021
Security Risk
Franking Credits
Inclusive
Yes
Scheduled
Conversion Date
22 March
2023
ASX Listed
Yes (Prospective ASX
Code: WBCPF)
Next Ex-Date
-
Convertible
Yes
Next Payment
Date
22 December
2015
GICS Sector
Banks
Next Cash
Distribution****
$1.24
Security Name
Westpac
Capital Notes 3
Upper Medium
Issuer
Outlook
Improving
Stable
Deteriorating
* Size is subject to change but we expect a final size of $750 million
** Based on prospective issue margin of 4.00% and 90-Day BBSW of 2.15%. Actual margin to be set at bookbuild.
*** Based on prospective issue margin of 4.00% and interpolated swap rate to the call of 2.70%. Actual margin to be set at bookbuild.
**** Actual cash amount not including franking value and based on $100 face value.
Summary
On 27 July 2015 Westpac Banking Corporation (WBC) announced a new transaction, Westpac Capital Notes 3 (Prospective ASX Code:
WBCPF). The purpose of this transaction is to provide funding for the group but more specifically it will be treated as additional Tier 1
capital for regulatory purposes. The size of the offer is indicated at $750 million but will change based on demand.
The capital notes are structured as perpetual, unsecured, convertible, transferable, redeemable and subordinated notes. Distributions
will be discretionary, fully franked, floating rate, non-cumulative and subject to payment conditions. They will be paid on a quarterly
basis based on a calculation equal to 90-Day BBSW plus a margin multiplied by (1 – Current Company Tax Rate). This margin will be set
at bookbuild and current guidance is [4.00 to 4.20%].
This security has no fixed maturity date but is scheduled for mandatory conversion into WBC ordinary shares on 22 March 2023,
subject to the conversion conditions being satisfied. At the issuer’s discretion, and subject to approval by APRA, the notes may be
redeemed/transferred or converted on 22 March 2021. As this security meets the new capital instrument eligibility criteria under
Basel III it also contains the loss absorbing terms and conditions known in the documentation as Capital and Non-Viability Trigger
Events. Upon the occurrence of these events this security will be converted into ordinary shares without the protection of conversion
conditions. The holder will receive the lesser of the conversion number and maximum conversion number as outlined in section 2
and 9 of the prospectus. If a situation arises where conversion is not possible for any reason, holder’s rights will be terminated and the
notes will lose all value.
Low Risk
Figure 1: Balance Sheet Structure1
0.1%
Figure 2: Relative Value
Tax Liabilities
8.00%
ANZPF, 7.08%
ANZPD, 6.70%
7.00%
WBCPD, 5.98%
NABPC, 6.52%
WBCPE, 6.79%
CBAPC, 5.76%
53.1%
Deposits
WBCPF, 6.70%
6.00%
ANZPE, 6.73%
CBAPD, 6.79%
High Risk
0.2%
1.0%
Life Insurance Policy Liability
Covered Bonds
26.5%
Senior Unsecured
11.3%
Other liabilities
0.8%
0.6%
Tier 2 Regulated Capital
6.4%
Common Equity
Tier 1 Regulated Capital
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Yield to Maturity
NABPB, 6.45%
5.00%
NABPA, 5.97%
4.00%
3.00%
2.00%
1.00%
1
2
3
4
5
Term to Optional Call (Years)
6
7
8
27 July 2015 | Page 1 of 5
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Research Report
Security Recommendation - Subscribe
This is the third listed security offered by Westpac which qualifies as Basel III compliant Tier 1 Capital (the last being offered in May
2014). In recent months the market has experienced a bout of volatility as broad market instability, capital uncertainty, tax loss
selling and supply side pressures began to pressure trading margins. However, since 30 June 2015 we have seen a retracement in
trading margins as the investor market finally understood that changes to capital adequacy requirements are a positive for bank
capital (tier 1 & 2 investors).
Westpac Capital Notes 3 has similar credit and structural risks to the other major bank securities, however it is being offered with
terms that make the valuation process more transparent. The term to expected maturity (optional redemption) is ~5.5 years which
is shorter than recently issued securities therefore less credit risk uncertainty and we have more conviction in our valuation. Our
assumptions for this part of the capital structure relative to more senior debt suggests a fair value spread below the current margin
offered. However, this type of security will always be subject to greater volatility than more senior securities from the same issuer
due the inherent equity risk.
Figure 3 shows the credit curve (trading margin) for comparable Tier 1 securities. This curve remains flat from 5 years onwards,
indicating investors are not being compensated for the additional term risk associated with longer dated securities. WBCPF is being
offered at the inflexion point in this curve, where the curve begins to steepen and the potential for capital upside is greater over the
short term. This confirms our comfort with the security valuation.
The risk of events such as non-viability or a capital event triggering conversion (or write off) are common across ‘new style’ Tier
1 securities, but we consider the probability of such an event for WBC to be remote in the current environment. Investors should
note these terms make the return profile asymmetric (unlimited downside but limited upside) and in all likelihood its performance
will have a higher correlation to equities than a traditional fixed income instrument during a period of stress. The most likely
scenario for a breach of these triggers would be either (or a combination of) a significant and sharp deterioration in the asset
quality of residential mortgages (which would effect all banks) or a failure of risk management within an institution that would lead
to significant losses (similar to the large losses taken by JPMorgan in 2012). If these events are triggered they are likely to cause a
significant capital loss to the investor.
All of these factors contribute to our recommendation but do not change our overarching strong outlook for the major banks and
that the risk around bank capital is reducing as a result of regulatory change and its focus on enhancing core equity. Subscribe.
Positive/Negative Risk Factors
Positives:
•
he domestic regulator (APRA) continues to implement strict controls over domestic banks with the Liquidity Coverage Ratio
T
(Net Stable Funding ratio implementation to be confirmed) becoming enforceable on 1 January 2015. This will significantly
improve the transparency to investors of risks other than capital;
•
The recommendations of the financial services inquiry are starting to become a reality. On 20 July 2015 APRA announced a
change to capital adequacy requirements in the form of increasing the average risk weights for residential mortgages from
~16% to at least 25%. Although this is at the low end of the recommendation (25-30%) it should be viewed as an interim change
while APRA awaits the Basel Committee on Banking Supervision (BCBS) review of risk weighted assets in general. The BCBS
review is due in December 2015 but the major banks must comply with APRAs new rules by 1 July 2016. This decision is a
positive for all holders of bank capital instruments as it reduces the common equity leverage. The reported Tier 1 ratios will not
look substantially different but the increase in nominal capital held increases the buffer against unexpected losses in mortgage
portfolios and in APRAs mind improves financial stability of the system. These changes (along with more changes to come) will
improve the standalone credit profile of the banks and their individual securities;
•
On 13 July 2015 APRA announced the results of the study comparing capital levels of the major banks. Although the major banks
have been reporting “internationally harmonised” capital levels for years there has not been an independent government
agency formally review the differences between global banks and Australian banks. The finding of this study were simply that
Australian banks were strongly capitalized but not in the top quartile of banks globally when measured by capital ratio. Hence,
APRA has indicated that (on average) the major banks had a shortfall of 2.0% for their Total Capital Ratio (of which of 0.70%
was attributable to the common equity tier 1 ratio) based on the 30 June 2014 reported capital ratios. While there is no formal
requirement from the banks to raise capital according to this study (this is likely to be included post the BSBC review). Westpac
has taken the initiative to reduce any potential capital shortfall through a series of capital initiatives including an underwritten
dividend reinvestment plan and partial sale of BT Investment Management;
•
Westpac Banking Corporation has a significant loss absorption cushion through earnings, capital and provisioning which are
the primary defenses of the bank to loan and security impairments. This is likely to increase further through the introduction of
the above capital adequacy requirements.
Negatives:
•
Distributions on this security are discretionary and subject to payment conditions. The primary risk here is that the minimum
common equity ratio (CET1) (inclusive of D-SIB and capital conservation buffers) required by APRA is increasing to 8.0% from
2016. This means that if WBC is unable to restore the CET1 ratio to a level above the minimum requirements, distribution
payments may not be able to be made. This is to ensure WBC is complying with APRA’s then current capital adequacy
requirements. This is partially mitigated by internal capital targets (8.75 to 9.25% CET1) and distribution and capital restrictions;
•
This security includes the Capital and Non-Viability Event trigger terminology. If breached, investors are at risk of substantial
capital losses. A sharp deterioration in earnings as a result of securities fraud (i.e similar to the London Whale event
experienced by JPMorgan) could adversely affect the loss absorption cushion of the group and result in an event whereby
conversion (or writedown) is triggered. This is an unlikely but possible event;
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27 July 2015 | Page 2 of 5
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Research Report
•
The findings of the APRA Capital Comparison Study suggest that APRA will require a ~2.0% increase in capital ratios. As we
expected, APRA has also indicated that Tier 1 and Tier 2 securities will also be used to reach these requirements. This increase
may put supply side pressure on trading margins and could in turn impact the security performance;
•
The announcement by the US Securities and Exchange Commission (SEC) in July 2014 to change the rules for securities that can
be purchased by prime money market funds could have significant impact on short term funding markets for Australian Banks.
The new rules state that at least 99.5% of a portfolio’s total assets must be in cash or government securities.
Issuer Outlook - Stable
Earnings
WBC reported statutory net profit of A$3.609 bn (cash earnings of A$3,778m) for the first half of 2015 (down 8% on the half but
unchanged on the year). The equity market reacted poorly as expectations for earnings growth was moderate but new accounting
treatments to fair value derivative assets had a significant impact on profit. WBC net mortgage lending growth was limited to 3%
(below system growth) over the period while the net interest margin dropped slightly to 2.01% (down 0.01%) and costs were well
controlled. This result was not the best ever produced by WBC, but the underlying performance of operating divisions was solid. It’s
our view that WBC is in a period of reflection in terms of market strategy and will not chase loan growth at the expense of quality.
Although this is not good for equity investors this is a strong attribute for debt and hybrid investors.
Capital
The core equity tier 1 (CET1) ratio fell 0.21% during the first half of 2015 from 8.97% to 8.76%. This drop was primarily attributed
to changes in the groups internal risk models for residential mortgages which increased the default probability for residential
mortgage loans (and hence the average risk weight from 14% to 16%). On 20 July 2015 APRA announced that the changes to the
capital adequacy requirements and as a result the average risk weight on Australian residential mortgages will increase to at
least 25% (our estimates had Westpac at 15.5% as at March 2015). Although this is a significant change to group capital planning
it was initially flagged in late 2014 and since then Westpac has initiated on a series of capital initiatives (underwritten dividend
reinvestment plan and partial sale of BT Investment Management) to partially offset the changes. WBC has until 1 July 2016 to
implement these changes and given their strong earnings capacity and easy access to capital we see no reason why then will not
meet these requirements.
WBC has a current Common Equity Tier 1 (CET1) target of 8.75%-9.25% but because of uncertainties with regard to future capital
settings, it will review its capital levels every six months. This uncertainty surrounding the calculation of global bank capital ratios,
how APRA will benchmark Australian banks against its peers and ultimately the timing to any changes in capital adequacy, will be
the key drivers of business strategy during this period of transition.
Asset Quality
The asset quality of WBC remains strong with gross impairment charges flat over the 6 months period on a nominal basis (0.11% of
average gross loans) and impaired assets reducing to 0.35% of gross loans. Specific provision coverage increased to 48% but this was
offset by a small nominal release in overall provisions. The delinquency ratio for Australian residential mortgages was 0.47% and
even lower on investment properties (~0.35%). Similar to its peers, WBC did report a small increase in delinquency rates on credit
cards up 0.26% to 1.08%. From a balance sheet perspective, the biggest risks in the loan book remain in the commercial real estate
(CRE) portfolio (~$50 billion) and the investment property portfolio. WBC has a market leading position in terms of asset quality and
all things remaining equal we do not expect this to change. The new lending criteria for residential mortgages could cause some
issues going forward but given its historical performance we do not think this will be an issue.
Funding and Liquidity
Liquidity and funding conditions have improved significantly over the past few years and the introduction of the Liquidity Coverage
Ratio (LCR) on 1 January 2015 means improved transparency for investors. WBC reported an LCR of 114% as at 31 March 2015,
based on qualifying liquid assets of A$123 billion (we note that WBC has $66 billion of its liquid assets derived from the RBA’s
committed liquidity facility and the reminder qualifying as High Quality Liquid Assets). This suggest the group is in a solid position
to manage any short term funding shocks. From a funding perspective customer deposits increased slightly on the half (3%) but
dropped slightly as a proportion of the reported Stable Funding Ratio (internal target set at 75, currently 83.2%). During the six
months ~$16 billion of term funding was issued which represents between 40-60% of the full year target depending on loan growth
and funding composition.
Outlook
The current operating conditions for WBC are strong with wholesale debt markets open (albeit stalled during the Greek emergency
funding discussions) and asset quality remaining strong. However, we expect over the next six months WBC will be focused on
changes to regulation around its residential mortgage book (both owner occupier and investor) as the new requirements (lower LTV
caps, higher average risk weights and cap on investor lending growth) will constrain loan growth while increasing minimum capital
requirements. WBC’s larger market share in the residential mortgage market means it is sensitive to macroeconomic changes (i.e
unemployment) and we will carefully monitor arrears rates on unsecured lending for signs of deterioration. However, given the low
interest rate environment and quality of the loan book we do not expect a significant deterioration in asset quality.
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27 July 2015 | Page 3 of 5
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Research Report
Figure 3: Credit Curve (Comparable Tier 1 Securities)2
4.50%
WBCPF, [4.00 - 4.20%]
NABPC, 3.97%
4.00%
WBCPE 3.87%
WBCPD 3.57%
Trading Margin
3.50%
ANZPD, 3.93%ANZPE, 3.88%
NABPB, 3.79%
ANZPF, 4.12%
CBAPD, 3.86%
NABPA, 3.56%
CBAPC, 3.38%
3.00%
2.50%
2.00%
1.50%
Credit Curve
Comparable Securities
1.00%
7.5
7.3
7.1
6.9
6.7
6.5
6.3
6.1
5.7
5.9
5.5
5.1
5.3
4.9
4.7
4.5
4.1
4.3
3.7
3.9
3.5
3.3
3.1
2.9
2.7
2.3
2.5
2.1
1.7
1.9
1.5
1.3
1.1
0.9
0.5
0.7
0.3
0.00%
0.1
0.05%
Term to Maturity
(Years)
Term to Optional
Call (Years)
Figure 4: Historical Trading Margins of Comparable Securities
7.00%
Trading Margin
Tradng Margin
6.00%
5.00%
4.00%
3.00%
2.00%
WBCPC
WBCPD
WBCPE
1
2
26/05/15
26/03/15
26/01/15
26/11/14
26/09/14
26/07/14
26/05/14
26/03/14
26/01/14
26/11/13
26/09/13
26/07/13
26/05/13
26/03/13
26/01/13
26/11/12
26/09/12
26/03/12
0.00%
26/05/12
1.00%
The balance sheet structure diagram represents a measure of liabilities and capital in order of seniority of the overall cash balance sheet.
Pricing as at close of business 23 July 2015.
Source: BondAdviser
www.bondadviser.com.au
27 July 2015 | Page 4 of 5
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Research Report
Analyst
Nicholas Yaxley
Credit Research
[email protected]
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At BondAdviser, our goal is to lift the lid on the fixed income
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Learn more
To learn more about the fixed income market visit our
website www.bondadviser.com.au
Important Information
Bond Adviser Pty Limited is authorised to provide general financial product advice under its Australian Financial Services Licence, with licence number 456783,
issued to it by the Australian Securities and Investments Commission. Some of the research in this report is based on past performance. Past performance is not an
indicator of future performance. Bond Adviser has taken all reasonable steps to ensure that no conflicts of interest have influenced the contents of this research
report. Bond Adviser has taken all reasonable steps to ensure that any opinion or recommendation in this report is based on reasonable grounds, and is not
influenced by any interests of Bond Adviser staff or other persons. The data generated by the research in this report is based on methodology that has limitations;
and some of the information in this report is based on information from third parties. Bond Adviser does not guarantee the accuracy, completeness or adequacy of
the research, opinions, recommendations or content of this report. This report includes both positive and negative research and product ratings. The research in
this report was not commissioned or funded by a third party service provider or product issuer. This report was created on 27 January 2015. Bond Adviser does not
guarantee the currency of the research. If you would like to assess the currency, you should compare the contents of this report with more recent characteristics
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