Interest on Tier 2 Notes
- is scheduled to be paid periodically (typically quarterly) in cash and does not carry Franking Credits
- may vary due to Market Rate movements (if interest is payable at a floating rate)
- will be paid on the scheduled payment dates, provided the Solvency Condition is satisfied
- is cumulative, meaning that any unpaid interest will accumulate over time and Tier 2 Note investors are entitled to any unpaid interest on the first date on which the Solvency Condition is satisfied
Calculating interest
Tier 2 Notes may pay fixed or floating rate interest, which is usually required to be paid quarterly or semi-annually. This will be set out in the Prospectus.
Generally, Tier 2 Notes pay floating rate interest which will be based on the Face Value of the Hybrid. Typically, the Interest Rate will be calculated as:
Interest amount = (Market Rate + Margin) x (number of days in the distribution period/365) x Face Value
Interest on Tier 2 Notes is payable in cash only and does not include Franking Credits.
Example
Assuming a Market Rate of 4.00% per annum, a Margin of 2.30% per annum, 92 days in the Interest Period and a Face Value of $100 the cash interest amount would be calculated as follows.
Cash interest amount
| Market Rate plus Margin (4.00% + 2.30%) | 6.30% per annum |
|---|---|
| Multiplied by number of days in Interest Period/365 | x92/365 |
| Multiplied by the Face Value | x$100 |
| Cash interest amount | =$1.5879 per Hybrid |
Market rate movements
The Interest Rate for a floating rate Tier 2 Note is driven by a Market Rate (which is likely to vary over the life of the Tier 2 Note) and a Margin (which will not vary). Movements in the Market Rate result in changes to interest payments on floating rate Tier 2 Notes. As the Market Rate fluctuates, there is a risk that a Tier 2 Note may become less attractive when compared to other investments.
It is possible for the Market Rate to be negative. If this occurs, the negative amount will be taken into account in calculating the Interest Rate. Even if the Interest Rate is calculated to be negative there will be no obligation on holders to pay the Bank.
Solvency condition
The Bank’s obligation to make payments on a Tier 2 Note is conditional on the Solvency Condition being satisfied. Broadly, the condition will be satisfied if:
- at the time the payment is due, the Bank is solvent; and
- the Bank would still be solvent immediately after making the payment.
The Prospectus may include a specific definition of what it means for the Bank to be “solvent”. For example, solvency may be defined in terms of the Bank’s assets exceeding its liabilities or as the Bank being able to pay its debts as they fall due.
If the Bank does not make a payment on a Tier 2 Note due to the Solvency Condition not being met, Tier 2 Note investors will have a right to receive that unpaid interest if the Solvency Condition is subsequently satisfied. However, if the Solvency Condition is never satisfied, unpaid interest may never be paid and Tier 2 Note investors will have no right to request the return of the investment, unless the Bank is wound up. If the Bank is wound up, Tier 2 Note investors may be entitled to bring a claim for unpaid interest, subject to more secure investments having been repaid by the Bank first.
Events of default
A Tier 2 Note will generally contain “events of default” which may entitle Tier 2 Note investors to take certain actions if the Bank fails to make a payment on a Tier 2 Note when due or if the Bank is wound up. An “event of default” will not be triggered by failure to pay due to the Solvency Condition.
The Prospectus will describe the events of default contained in a Tier 2 Note and the actions which can be taken as a consequence. These are more limited than the events of default typically included in more secure investments. In particular, a Tier 2 Note investor has no rights to require its investment to be returned to it unless the Face Value of the Tier 2 Note is due upon maturity or the Bank is wound up.
Understanding Tier 2 Note terms
Tier 2 Notes typically have an Optional Redemption feature that applies at least five years from Issue Date. The maturity date is usually at least ten years from the Issue Date.
Optional Redemption
There are typically two circumstances in which the Bank can, at its option (but subject to certain conditions), redeem a Tier 2 Note prior to its maturity date by repaying the Face Value in cash.
The Bank may choose to redeem a Tier 2 Note when:
- an Optional Redemption Date occurs (this date must be at least 5 years after the Issue Date).
- a Tax Event or Regulatory Event occurs (these events could occur at any time).
If one of these events occurs, the Bank may choose to redeem all or some of the affected Tier 2 Notes, subject to satisfying the Conditions to Optional Redemption. Tier 2 Note investors have no right to request Optional Redemption and should not assume that the Conditions to Optional Redemption will ever be satisfied, or that the Bank will exercise its discretion to redeem any Hybrids.
Tier 2 Note investors face uncertainty as to whether the Bank will decide to redeem a Tier 2 Note and whether APRA’s approval, if requested, will be given. A decision as to whether or not to redeem a Tier 2 Note may not suit all Hybrid investors.
Repayment at maturity date
Tier 2 Notes include a fixed date on which the Face Value is required to be repaid to the Tier 2 Note investor, subject to the Solvency Condition being met. This date is referred to as the “maturity date” and will be set out in the Prospectus. The maturity date will typically be 10 years or more after the Issue Date and must not be less than five years after that date.
On the maturity date, subject to the Solvency Condition being satisfied, a Tier 2 Note investor will receive the Face Value plus any accrued and unpaid interest for each Tier 2 Note that they hold.
A Tier 2 Note investor will not receive any payment on the maturity date if the Solvency Condition is not satisfied or if the Tier 2 Note is no longer on issue (for example, if it has already been redeemed, Converted or Written-Off).
A Tier 2 Note may also be impacted by an Optional Redemption due to a Tax Event or Regulatory Event.
Loss Absorption
Conversion or Write-Off may apply at any time due to the occurrence of a Non-Viability Trigger Event.
Non-Viability Trigger Event
If a Non-Viability Trigger Event occurs, Tier 2 Notes will be Converted or Written-Off to the extent required by APRA.
In summary, a Non-Viability Trigger Event occurs when APRA has provided a written determination to the Bank that:
- a Conversion or Write-Off of Hybrids is necessary because without the Conversion or Write-Off, APRA considers that the Bank would become non-viable, or
- without a public sector injection of capital into, or equivalent support with respect to, the Bank, APRA considers that the Bank would become non-viable.
If a Non-Viability Trigger Event occurs, the Bank must Convert or Write-Off some or all of its Hybrids on issue (as required by APRA). If APRA does not require all Hybrids on issue to be Converted or Written-Off, Tier 1 Hybrids will be Converted or Written-Off before Tier 2 Notes. These actions are designed to help the Bank absorb losses and are likely to result in a Hybrid investor suffering a loss on their Hybrid investment. If Tier 2 Notes are Written-Off, Tier 2 Note investors will have no claim on the Bank (even though Ordinary Shares may still be on issue) and Tier 2 Note investors are likely to be worse off than holders of Ordinary Shares.
Investors should note that APRA will not approve partial Conversion or partial Write-off in those exceptional circumstances where a public sector injection of funds is deemed necessary.
What does “non-viable” mean?
In relation to Non-Viability Trigger Events, APRA’s prudential standards do not define non-viability and APRA has not provided specific guidance as to how it would determine non-viability. However, APRA has indicated that non-viability is likely to arise prior to the insolvency of an ADI. Non-viability could be expected to include serious impairment of a Bank’s financial position. However, it is possible that APRA’s view of non-viability may not be confined to solvency or capital measures and APRA’s position on these matters may change over time. Non-viability may be significantly impacted by a number of factors, including factors which affect the business, operation and financial condition of a Bank. For instance, systemic and non-systemic macroeconomic, environmental and operational factors, domestically or globally, may affect the viability of a Bank.
Loss Absorption: Conversion or Write-Off
What is a Tier 2 Note investor likely to receive if a Tier 2 Note is Converted due to a Non-Viability Trigger Event?
If a Tier 2 Note is Converted following a Non-Viability Trigger Event, the Tier 2 Note investor will receive Ordinary Shares in exchange for their Tier 2 Note. The number of Ordinary Shares that a Tier 2 Note investor receives on Conversion following a Non-Viability Trigger Event is determined by a formula which is based on the VWAP during a period leading up to the Non-Viability Trigger Event and is capped at the Maximum Conversion Number. Details of the formula will be set out in the Prospectus.
The Maximum Conversion Number will apply if the VWAP at the time of the Conversion has fallen to or below 20% of the Issue Date VWAP. If the Maximum Conversion Number applies, this is likely to result in Tier 2 Note investors receiving significantly less than $101 worth of Ordinary Shares per Tier 2 Note (assuming a Face Value of $100).
The VWAP at the time of a Non-Viability Trigger Event is likely to be substantially lower than the VWAP at the time when the Tier 2 Note was issued. This means that the Maximum Conversion Number may well apply and Tier 2 Note investors may lose all or a significant amount of their investment. In addition, there may be no market for Ordinary Shares received on Conversion.
If a Tier 2 Note is Converted, the Tier 2 Note investor will cease to have any further rights as a Tier 2 Note investor. Instead, they will become a holder of Ordinary Shares in the Bank and have the rights (and bear the risks) associated with that investment.
Example - number of Ordinary Shares that a Tier 2 Note investor would receive on Conversion following a Loss Absorption Event (Non-Viability Trigger Event)
Assumptions:
Face Value: $100
Issue Date VWAP: $25
Current VWAP: $1
The number of Ordinary Shares issued on Conversion following the Loss Absorption Event is calculated as the lesser of: the Maximum Conversion Number (1) and the number given by the Conversion formula in the Prospectus (2).
(1) Maximum Conversion Number:
Face Value/(Issue date VWAP x 20%)
= 100/($25 x 20%)
= 20 Ordinary Shares per Hybrid.
(2) Conversion formula:
Face Value / 99% x Current VWAP.
= $100/ (0.99% x $1)
= 101 Ordinary Shares per Hybrid.
In this example, the Maximum Conversion Number is less than the number given by the Conversion formula, so the Maximum Conversion Number would apply and Hybrid investors would receive 20 Ordinary Shares per Hybrid. A Hybrid investor with 100 Hybrids would be allocated 100 x 20 = 2,000 Ordinary Shares.
At an Ordinary Share price of $1, the total market value of those Ordinary Shares would be 2,000 x $1.00 = $2,000, compared to the original $10,000 investment on the Issue Date. Assuming the Ordinary Shares are able to be sold at $1 (which may not be possible), the Hybrid investor would incur an $8,000 loss (excluding any brokerage costs).
What is a Tier 2 Note investor likely to receive if a Tier 2 Note is Written-Off?
If Conversion following a Non-Viability Trigger Event does not happen within 5 days, the Tier 2 Note will be Written-Off.
If a Tier 2 Note is Written-Off, all of the Hybrid investor’s rights in relation to their investment are terminated. The Tier 2 Note investor will lose their entire investment and will have no further rights in respect of their Tier 2 Note. If this occurs, Ordinary Shares may still be on issue, and Tier 2 Note investors are likely to be worse off than holders of Ordinary Shares.
Example – Write-Off
If a Hybrid investor’s 100 Tier 2 Notes issued to that investor on the Issue Date at $100 per Hybrid are Written-Off, their entire investment in the Tier 2 Note will be terminated and the Hybrid investor will incur a 100 x $100 = $10,000 loss.
Order of Conversion of Tier 1 Hybrids and Tier 2 Notes
There are some cases in which APRA may require a Bank to Convert or Write-Off all of its Tier 1 Hybrids and Tier 2 Notes due to a Non-Viability Trigger Event. In other cases, APRA may determine that the Bank only needs to Convert or Write-Off a proportion of Hybrids on issue. If APRA requires the Bank to Convert or Write-Off less than all Hybrids on issue, the Bank must Convert or Write-Off all Tier 1 Hybrids before Converting or Writing-Off Tier 2 Notes. This means that, in certain circumstances, Tier 1 Hybrids may Convert before Tier 2 Notes and Tier 1 Hybrid investors may suffer losses before Tier 2 Note investors.
Banks have no obligation to issue or maintain Tier 1 Hybrids on issue (subject to their terms) and Tier 2 Note investors should not assume that they will do so.
Accessing Tier 2 Notes
Investing as part of the initial offer
An investor can invest in a Hybrid when it is first offered. Investors who invest at this time will pay the Face Value for each Hybrid and the Hybrid will be issued on the Issue Date.
Buying and selling Hybrids on the ASX while on issue
Hybrids are typically quoted on the ASX. This means that investors may be able to buy or sell Hybrids on the ASX at the quoted price applicable at the time. This is known as the “secondary market”. There is no guarantee that the secondary market will always be as liquid, or the quoted price as stable, as buyers and sellers would like.
In addition, trading prices on the secondary market may be affected by a range of factors, such as Australian and worldwide economic conditions, prevailing interest rates, how the Interest Rate of the Hybrid compares to that of other comparable instruments and the Bank’s financial performance. Hybrid investors face uncertainty as to how the market price of their investment will perform over time. It may go up or down, and there is no guarantee that the Hybrid will be traded at or above its Face Value, or at all.
The market price of a Hybrid is uncertain. It may go up or down and there is no guarantee that a liquid market will exist. If a Hybrid investor wishes to sell a Hybrid on the market, they will be subject to the prevailing market price, which may be lower than the Face Value invested.
Example – Loss from sale on the secondary market
A Hybrid investor who purchased 100 Hybrids at $100 per Hybrid in the initial offer decides to sell their Hybrids on the secondary market some time later, where the current ASX market price is $95 per Hybrid.
In this example, the Hybrid investor will make a $500 capital loss ($10,000 - $9,500), excluding any brokerage costs.
Summary of Tier 2 Note features
| When does this happen? | Is APRA approval needed? | Do conditions apply? | What value will Hybrid investors receive? | In what form will that value be provided? | |
|---|---|---|---|---|---|
| Periodic interest payments |
When does this happen?
On each interest payment date
|
Is APRA approval needed?
No
|
Do conditions apply?
Yes, subject to the Solvency Condition
|
What value will Hybrid investors receive?
Amount determined by Interest Rate
|
In what form will that value be provided?
Cash
|
| Secondary market sale of investment |
When does this happen?
At the investor’s discretion, subject to market conditions
|
Is APRA approval needed?
No
|
Do conditions apply?
N/A
|
What value will Hybrid investors receive?
Prevailing market price at the time of sale, less any brokerage costs
|
In what form will that value be provided?
Cash
|
| Optional Redemption |
When does this happen?
On the scheduled date or if a Tax Event or Regulatory Event occurs
|
Is APRA approval needed?
Yes
|
Do conditions apply?
Yes
|
What value will Hybrid investors receive?
$100 per Hybrid
|
In what form will that value be provided?
Cash
|
| Redemption at the Maturity Date |
When does this happen?
On the scheduled date
|
Is APRA approval needed?
No
|
Do conditions apply?
Yes
|
What value will Hybrid investors receive?
$100 per Hybrid
|
In what form will that value be provided?
Cash
|
| Conversion due to a Loss Absorption Event |
When does this happen?
If a Non-Viability Trigger Event occurs
|
Is APRA approval needed?
No
|
Do conditions apply?
No
|
What value will Hybrid investors receive?
Depending on the market price of Ordinary Shares, significantly less than the Face Value
|
In what form will that value be provided?
Variable number of Ordinary Shares
|
| Write-Off due to a Loss Absorption Event |
When does this happen?
If a Non-Viability Trigger Event occurs and Conversion of the Tier 2 Note has not occurred within 5 days.
|
Is APRA approval needed?
No
|
Do conditions apply?
No
|
What value will Hybrid investors receive?
$0
|
In what form will that value be provided?
N/A
|
Hybrid Securities Education
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