Are Bank Bonds with Over 10% Returns Reliable?

Introduction:

Australian Small Bank Judo Bank

Bond Products with Returns up to 10.5%

The Three Main Reasons for Judo Issuing High-Interest Debt

The Vast AT1 Bond Market and How Investors Choose

Looking at the Development Challenges of New Digital Banks in Australia from Judo

Recently, an Australian small emerging bank, Judo Bank, has frequently appeared on the front pages of major news websites, with many securities firms strongly promoting it, showing a strong momentum.

It is well known that Australia's banking regulatory system is among the strictest in the world. As a homegrown Australian bank, Judo has surprisingly issued bond investment products with returns as high as 10.5%, which has shocked the market.

Does the principle of high returns and high risks not apply to this bank?

Or is it that the products issued by the bank itself still have potential pitfalls and risks?Why does Judo incur such high costs for financing?

For investors, how should they choose such products?

Australian Small Bank Judo Bank

Judo Capital Holdings Limited is a publicly listed financial company in Australia and the parent company of Judo Bank. As a small emerging digital bank, Judo Bank has no physical branches, and its main customer base consists of small and medium-sized enterprises (SMEs).

Unlike the four major banks, each customer manager at Judo is responsible for only 30 clients, adopting a relationship-based development strategy. This approach maintains close contact with clients, selects higher-quality clients, increases client retention, and helps to detect and resolve loan issues at a very early stage of abnormality.

As a result, the 90-day loan delinquency rate for corporate business loans issued by Judo is only 1.09%, significantly lower than the industry average of 2%.

Although the current market share is less than 2%, the loan scale of SMEs accounts for 45% of Australia's domestic commercial loans, and loan income accounts for more than half. There is a very strong growth potential in the future.

On the other hand, the high interest income from SME loans also brings higher risks than mortgage loans to Judo. Judo's clients are concentrated in three major fields: retail, real estate, and builders. In the current economic environment, these enterprises have a higher risk of bankruptcy and default.

Therefore, Judo has always maintained a super high capital adequacy ratio, with the common equity tier 1 capital ratio (CET1 ratio) reaching 16.7%, far higher than the industry regulatory requirement of 4.5%. The bonds issued this time are also to provide Judo with more sufficient funds to meet regulatory requirements.

The bond product with a yield as high as 10.5%Judo Bank Capital Notes are a hybrid security product issued by Judo, providing funding for the bank's Additional Tier 1 Capital (AT1). The financing amount is AUD 75 million, with a term of 8 years and an interest rate of 6.25%-6.50% + 3 month BBSW (approximately 10.45%-10.70%), paid quarterly.

While the returns may seem high, these bonds typically come with complex terms and two significant risks that are often overlooked:

1. Judo holds all the control, and investors have no right to demand conversion, redemption, or resale at any time. The dividends are non-mandatory and non-cumulative, with no obligation for Judo to pay interest, and this does not constitute a default.

2. AT1 bonds are subordinated unsecured securities, with a priority ranking only above common shares, and without any collateral. They can be written off or converted into equity before any other creditors suffer any losses.

Moreover, it is highly likely that Judo, like other banks issuing similar products, will choose to redeem the bonds at the first call date rather than waiting until the maturity date eight years later. At that time, investors may face the risk of having to reinvest in similar products at a lower interest rate.

The interest and principal of these bonds are at risk of total loss, with the principal loss potentially exceeding that of shareholders under very specific terms. This was particularly evident earlier this year when Credit Suisse was acquired by UBS, triggering such a scenario.

At that time, to alleviate the distress, Credit Suisse's AT1 bonds, valued at $17.5 billion, were written down to zero, leaving investors with a total loss; however, shareholders, who were ranked after bond investors in the order of claims, received $3.22 billion in compensation, retaining nearly 50% of their equity, causing a shock in the capital market.

Although it may seem counterintuitive, such actions by banks are actually in line with the legal terms of these securities. The bonds issued by Judo this time also have the same design, clearly stating in their conversion clause for absorbing losses:

In the event of an extreme situation, capital notes and other related Tier 1 capital instruments will need to be immediately converted into common shares. However, if for any reason the conversion is not completed within five business days after APRA confirms the occurrence of the relevant event, all bonds will be written off and irrevocably terminated, with investors losing all their investments without any compensation.

If we look at the actual terms, it can be seen that these bonds stipulate that dividends cannot be paid to shareholders before the corresponding interest is paid. However, in the event of an unforeseen crisis at the bank, the bank can unilaterally write off this bond directly, even before the shareholders' equity is reduced to zero, leaving investors potentially with nothing to show for their investment.In other words, the part where it is superior to equity is actually the interest being better than dividends, but the principal repayment order might be lower than that of shareholders. Therefore, behind this high yield, the potential loss that investors may have to bear could be higher than what is commonly understood for debt investments.

Thus, the core risk of such bank convertible bonds lies in the extent to which the bank may face severe operational difficulties, the possibility of bankruptcy, or restructuring. According to the terms of the convertible bonds, if such a situation arises, these bonds might be the first to be completely written off by the bank ("defaulted"). On the contrary, as an industry under strict regulation, especially one that strictly controls capital and cash flow, the corporate governance and cash flow management of listed banks should be relatively strict and formal. The possibility of them being unable to pay interest due to their own amateurish operations is not high, especially for those banks that can maintain profitability over the long term.

Since the issuance of this note by Judo has set a record for the highest coupon rate of securities issued by Australian banks in recent decades, it has not only impacted investors' views but also sparked heated discussions within the industry. So, why does Judo use convertible bonds with such a high cost of financing?

There are three main reasons for Judo to issue high-yield debt:

Firstly, to meet the bank's capital regulatory requirements:

Judo holds 2.3 billion Australian dollars of ultra-low-interest TFF funds provided by the RBA, with an interest rate of only 0.1%, which will mature in June 2024. Currently, this fund accounts for 24% of Judo's total capital. After maturity, it will need to be refinanced through other means, including the issuance of AT1 or T2 bonds, to meet the capital regulatory requirements of the banking industry.

Using such high-yield financing is not a long-term strategy for Judo, but because Judo currently holds less than 1% of the term deposit market share, once the bank grows to scale, it will reduce the proportion of high-yield financing to 15-20%, increase the proportion of term deposits from the current 50% to 70-75%, and reduce the overall financing cost of the bank.

Secondly, Judo adopts a high-yield business model that can guarantee interest payments:

The interest on small and medium enterprise loans, which is Judo's main business, is higher than that on mortgages, with a net interest margin as high as 3.34%, while CBA's net interest margin is only 2.07% during the same period.Estimated, Judo's loan interest income is approximately 8.6%, which is sufficient to cover the interest costs of convertible bonds.

Judo has never paid dividends, nor does it have plans to do so in the near future, retaining ample capital to pay the interest on convertible bonds.

The interest rates on Judo's recently issued T2 bonds and senior unsecured bonds are both relatively high, and the risk of AT1 bonds is higher than that of T2 bonds. With the central bank raising interest rates, the premium of 6.25%-6.50% this time falls within a reasonable range.

Lastly, Judo's own risk is higher than that of the big four banks but lower than other high-risk peers:

Judo's rating is only BBB-, with a market share of less than 2%, making its risk relatively higher compared to the big four banks, necessitating higher returns to attract investors.

However, compared to other financial institutions in the industry that provide consumer loans or other services, the premium is relatively reasonable.

Therefore, although it is not common for financing products issued by regular banks to yield more than 10%, considering the characteristics of Judo's main business and the current situation of high-cost financing in the capital market, the high interest offered by Judo is also understandable.

The Australian AT1 bond market is large, how do investors choose?

In addition to Judo, other major banks in Australia also raise funds by issuing AT1 bonds.

Bank of Queensland (BOQ) issued BOQ Capital Notes 3 at the end of last year. Due to strong demand, the financing scale increased from 300 million to 400 million Australian dollars, with a term of 9 years and an interest rate of 3.40%-3.60% + 3 month BBSW (approximately 6.43%-6.63%), paid quarterly.In February of this year, ANZ issued a similar product, ANZ Capital Notes 8, with an interest rate of only 2.75%-3.00% + 3 month BBSW (approximately 6.24%-6.49%), with a scale of 1 billion Australian dollars.

Therefore, the larger the issuing bank, the smaller the operating risk, the more stable the capital structure, and the stronger the financing ability; the investment risk of the issued AT1 bonds will be smaller, and the interest will correspondingly decrease.

At present, the scale of Australia's AT1 bond market is about 40 billion Australian dollars, of which small retail investors hold about half of the share. After each period of AT1 bonds matures, banks usually choose to redeem at the first call date, rather than convert into shares. Existing investors will receive the last dividend and the return of the principal, and can also choose to continue to invest in the newly issued AT1 bonds.

In the second half of 2022, the industry issued the largest AT1 bonds in history, mainly because at that time, WBCPE, NABPD, and CBAPD had a total of about 6 billion Australian dollars of AT1 bonds maturing, and banks were refinancing.

It can be inferred that the next peak period for issuing AT1 bonds will be in the first half of 2024, when about 40 billion Australian dollars of bonds will mature, and a large number of AT1 bonds will be refinanced.

However, in view of the write-off of Credit Suisse's AT1 bonds, which has caused global concern in the banking industry, and there are a large number of retail investors in Australia's AT1 bonds, APRA is considering restricting the issuance of Australian bank AT1 bonds, including:

Considering the risk of AT1 bonds, limiting the participation of retail investors

Improving the design of AT1 bonds to ensure that they can be used to stabilize bank crises at an earlier stage and avoid bankruptcy

Changing bank regulatory capital requirements to reduce banks' dependence on AT1 funds

For retail investors, this type of investment product is more suitable for the following groups of people:Pursuing long-term cash flow income without considering capital appreciation

Seeking long-term investment without considering the liquidity of the principal

Able to bear certain risks, including potential dividend instability, interest rate reductions, early redemption or conversion, and partial or total loss of principal

Secondly, when making investments, investors can also screen among similar types of products:

Prioritize AT1 bonds from the four major banks, which have guaranteed profitability and a verifiable record of stable dividends

Can be directly traded on the ASX, offering a certain level of liquidity

Redemption is guaranteed, reducing the risk of principal loss

Expanding the topic - The development challenges of new digital banks in Australia as seen through Judo

Returning to Judo Bank itself, as a small digital bank, the current loan portfolio amounts to 8.9 billion Australian dollars, which is still far from the scaled target of 15 to 20 billion Australian dollars.

In a phase where the entire banking industry faces mid-to-short-term challenges in revenue growth and high cost pressures, the outlook for FY24 is not optimistic. After repaying the low-interest funds from the RBA, the net interest margin will inevitably decrease, leading to a reduction in profit margins.However, the company's business model is already very clear, maintaining a purely online operation model without setting up offline outlets. Focusing on the existing small and medium-sized enterprise (SME) lending and relationship network operation model, each account manager still serves no more than 30 clients, ensuring that the company's high-risk SME lending business can detect and resolve issues at an early stage to reduce the overall non-performing loan rate.

Therefore, although the overall market share is less than 2%, Judo has already secured a place in the niche market it focuses on.

In addition to finding the right track, the more severe challenge faced by new digital banks is the fierce competition from mainstream banks. Currently, 98.9% of transactions from major Australian banks come from online, with only 0.4% of transactions completed in offline branch stores. In the three years of the pandemic, the interaction volume in offline stores has decreased by 46%, while the online interaction volume has increased by 26% [JW4] [RG5].

To meet the surging online demand, in the fiscal year of 2022 alone, the three banks, CBA, Westpac, and ANZ, spent 28.5 billion Australian dollars on IT capital expenditures, which is 10 times the expenditure on offline stores and offices.

ANZ even spent 220 million Australian dollars in 2019 to acquire the leading digital bank 86400 at the time and incorporated it into its digital bank Ubank.

In other words, large banks are also gradually transforming into online banks.

Due to the sharp rise in financing costs and the limited expandability of the local market, the survival space for new digital banks is likely to be further squeezed in the foreseeable future.

When making any investment, please consider the applicability of the information contained in this article based on your personal investment objectives, financial situation, or personal needs, make decisions cautiously, and bear the risks yourself.