Strong earnings and attractive yields weigh in favour of bank bonds
Singapore bank bonds have been relatively popular this year; senior and Tier-2 subordinated bonds are attractive
SINGAPORE dollar-denominated bank bonds continue to be one of the most popular corporate bonds in 2023, despite also being the most controversial at the beginning of the year.
Year to date, bonds issued by the financial sector represent the majority of the Singapore dollar (SGD) issuances at close to 74.4 per cent, according to Bloomberg. This figure is the highest we have seen in recent years, greatly exceeding the 55.5 per cent in 2020, 53 per cent in 2021 and 45.9 per cent in 2022. Likewise, the volume of issuances by the financial sector has been the highest in recent years.
HSBC 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 S$2.275 billion. 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, Singapore bank bonds have been beneficiaries of a flight to safety, despite the write-down of Credit Suisse Additional Tier-1 (AT1) bonds in March. We see a couple of reasons behind this.
First, banks typically offer levels of seniority 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 of 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). Most major banks hold relatively strong credit ratings. Generally, AT1 bonds are rated below investment grade. With attractive credit ratings, senior and Tier-2 subordinated bonds continue to be popular, especially in a dry season of issuances.
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Second, banks continue to reap the rewards of high interest rates. Since the beginning of the rate hikes, most banks have had rising profitability with stronger net interest income. In Singapore, DBS, OCBC and UOB had record profits 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 fewer or smaller rate hikes, we believe banks continue to benefit from profit tailwinds. Most banks expect rates to peak soon and expect to have lower forward-looking provisions on credit losses – benefiting the banks’ loan books. Lastly, profitability during this period has helped to build banks’ core capital, allowing for improved buffers against losses.
Since the write-down, we favour 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 less 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 maturity. Duration risk is generally minimised 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 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 incentivised to refinance 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 bonds. We would like to highlight two reasons. First, we feel that investors have yet to adequately price in the risk of loss absorption. Second, the risk of non-call remains high for perpetual securities, given the elevated interest rates and potentially higher-for-longer interest-rate environment.
In terms of the first reason relating to loss absorption, the write-down of Credit Suisse AT1 bonds brought the risk of loss absorption to the spotlight. We felt the initial price declines were fair in addressing the actual risk. However, prices of most SGD AT1 issuances have returned to the prices prior to the Credit Suisse AT1 write-down event.
We would like to note that the Credit Suisse AT1 issuances are 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 inadequate in terms of compensating investors for the risk that they are undertaking.
In terms of the second reason relating to interest rates, rising interest rates resulted in fewer calls across perpetual securities, even though we continue to see most major and regional banks redeem their AT1 perpetuals.
The risk of non-calls continues to be high given the increased cost of debt and higher-for-longer interest rates. In some cases, it may no longer be economically viable for the bank to redeem and refinance its AT1 perpetual bonds. Investors ought to consider the possibility of non-calls should they choose to invest in perpetuals, and whether such a scenario is acceptable in their investment portfolio.
Overall, bank bonds remain popular for a reason, but should be looked at objectively. Senior unsecured bonds would be the preferred option given the need for quality amid an uncertain economic environment. Otherwise, Tier-2 subordinated bonds offer relatively good yield pickup for minimal added risk.
The writer is a fixed income analyst of the Bondsupermart Team at iFast Financial, the Singapore subsidiary of mainboard-listed iFast Corporation.
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