One of the initially-overlooked parts of S&P’s recent review of the credit ratings of Australian financial institutions is a paragraph referring to hybrid debt and non-deferrable subordinated debt. Even though S&P has not downgraded the major banks’ senior debt credit ratings, it has however lowered by one notch its ratings on hybrids and subordinated debt issued by the major banks and their banking subsidiaries. It has done so on the basis government support is unlikely to be extended to these types of securities should the banking sector experience substantial losses.
On the face of things, a one notch downgrade does not seem overly important. However, in more than a few cases, ratings for securities have moved from BBB-, which is investment grade, to sub-investment grade BB+. This is where the problems could begin.
Investment funds which are prohibited from holding sub-investment grade securities, or those which have reached their limits of sub-investment grade securities, will need to dispose of those holdings which are now in breach of their mandates. How these disposals affect yields in the short term will depend on the rate at which they occur and the liquidity of the relevant securities. Common sense would infer additional supply of any asset over and above the “natural” rate will lead to a decline in the price and thus a higher yield.
* Change in trading margin from close of business 19 May 2017 to close of business 23 May 2017