First State Super is positioned to take advantage of what it has identified as an “underappreciated risk” to global fixed income markets from the next phase of the Basel III international banking reforms.
When Basel III’s net stable funding ratio (NSFR) requirements come into effect on January 1, 2018, banks will start preferring longer-term funding. This will dry up liquidity in the short-term fixed income market and make it harder for funds to earn a decent return in this part of their portfolio.
But institutional investors with large balance sheets have the opportunity to partner with banks and net attractive returns for members, First State Super head of treasury and dealing Michael Clavin said.
Under the NSFR requirements, securities with a timeframe longer than one year are considered stable and can be included in the ratio. Securities under one year carry less weight, meaning banks will opt to buy and issue longer-term bonds and notes. Australian banks will no longer be the major actor in the short-term market. The change will cause yields in this market to decrease over time, Clavin said.
“The logical buyer of shorter-term securities will [be] the Reserve Bank of Australia, but can it act quickly enough? As an institutional investor, you have to understand the risk to the broader fixed income market. I think it is an underappreciated risk.”
‘Tremendous’ opportunities for investors
As Australian banks scramble to shore up capital reserves to meet the January deadline, First State – the $80 billion default superannuation fund for NSW public servants – has identified an opportunity in the form of its long-term and stable balance sheet.
“From January 2018, we are not going to be a useful source of capital for banks unless we go out past six months and ideally 12 months,” Clavin says. “So we have started looking at our balance sheet as an asset and how we can use it in this new environment. There are challenges, but there are also a tremendous number of opportunities.”
Calling on his experience undertaking similar trades with European banks – the first ones to start implementing Basel III, in 2013 – Clavin has been brokering unique arrangements with domestic and investment banks in Australia.
Trades include tailored ‘at-call’ accounts with domestic banks that allow the fund to hold liquidity and the banks to limit their capital holding requirement under the NSFR. Clavin is also looking to do security finance trades with investment banks, where his fund delivers cash and bonds in a fully collateralised arrangement and receives a premium.
“The Australian bank industry is not the most diverse market in the world,” he says. “You have to take that into account in terms of pricing and how you structure the trade. I look at the entire liquidity position of First State Super and then engage a bank with confidence about how stable the funding for the trade will be. It is not impossible to do as an asset manager but it is harder.”
Clavin recommends asset owners start looking at what this significant change in the fixed income market means for their portfolio, if they haven’t already.
“Fixed income is still regarded as the liquid part of the portfolio but there will be a time when that won’t hold true.”
Michael Clavin will participate in a panel discussion titled “The effect of regulations on fixed-income markets” at the Investment Magazine Fixed Income, Cash and Currency Forum in Healesville, Victoria, on July 25-26, 2017. For registration enquiries, contact Emma Brodie: +61 2 9927 5708, [email protected] or visit the event website.
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