Key Characteristics. Product Type. Fixed/Floating. Payment Frequency Current Distribution** Issue Margin / Coupon Franking Credits Incl.

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1 Report Created on 22 November 2017 Issuer Name Bank of Queensland Limited Security Name Bank of Queensland Limited Capital Notes Security Recommendation Subscribe Security Risk Upper Medium Issuer Outlook Improving Stable Deteriorating Key Characteristics Product Type Capital Note Issue Size* $300,000, Par Value $ Fixed/Floating Payment Frequency Current Distribution** Issue Margin / Coupon Franking Credits Incl. ASX Listed Convertible GICS Sector Floating Quarterly 5.470% [3.750% %] Yes Yes (ASX Code: BOQPE) Yes Banks Last Price $ Accrued $0.00 Capital Price $ Running Yield** 5.470% Yield to Maturity*** 6.272% Trading Margin [3.750% %] Optional Call Date 15 August 2024 Legal Final Maturity Perpetual Next Ex-Date 24 January 2018 Next Payment Date Next Cash Distribution**** 15 February * Issue size may subject to change. ** Based on prospective issue margin range below and assumed to be [3.75%] plus 90-Day BBSW. *** Based on issue margin and an interpolated swap rate to call of %. **** Actual cash amount based on $100 face value. Summary On 13 November 2017, Bank of Queensland Limited ( BOQ ) issued an offer for Bank of Queensland Limited Capital Note (expected ASX Code: BOQPE), to raise $300 million, with the ability to raise more or less, accompanied by a reinvestment offer for holders of the existing Bank of Queensland Convertible Preference Shares (CPS, ASX Code: BOQPD). These securities are structured as perpetual, subordinated, unsecured, and convertible. Distributions are expected to be discretionary, noncumulative, floating rate, fully franked, and paid on a quarterly basis in arrears until converted or redeemed. The securities will be issued on 28 December 2017 and the purpose of this transaction is to partially repay the $300 million CPS (BOQPD) through the reinvestment offer, with the remainder potentially redeemed at the discretion of BOQ, on 15 April 2018, and to be used for general corporate and funding purposes. The margin on this security is expected to be set at [3.75% %] p.a above the 90-Day BBSW. This security has no fixed maturity date but is scheduled for mandatory conversion into BOQ ordinary shares on 15 August 2026, or later, when conversion conditions have been satisfied. At the issuer s discretion, and subject to approval by APRA, the notes may be redeemed/transferred or converted on 15 August As this security meets the new capital instrument eligibility criteria under Basel III, it also contains the Loss Absorbing Events terms known in the documentation as either a Common Equity Trigger Event or a Non-Viability Trigger Event. The security therefore qualifies as Additional Tier 1 capital. Upon the occurrence of either of these events this security will be automatically converted into ordinary shares or written off without the protection of conversion conditions. Conversion calculation ratios are set based on issue date VWAP and will be updated once known. If conversion cannot occur for any reason the notes will be written off and all holders rights terminated. Figure 1: Capital Structure 1 Figure 2: Relative Value 2 0.2% Deferred Tax Liability 65.4% Deposits 0.1% 12.4% 13.9% 0.7% 0.6% Life Insurance Policy Liabilities Senior Unsecured Other liabilities Tier 2 Regulated Capital Tier 1 Regulated Capital Common Equity 22 November 2017 Page 1

2 Security Recommendation - Subscribe as at 22 November 2017 BondAdviser recommends investors Subscribe to this security. As a regional bank in Australia, issuances from BOQ should in theory always trade at a premium to the major banks regardless of capital structure position. Our relative value analysis suggests that although we are comfortable with the credit profile of the issuer, we see limited upside in the current trading margin over the recommendation horizon. This is predominantly because the credit profile of BOQ is of somewhat higher risk than the major banks as its loan book is not as diverse (geographic and by type), and the quality of the collateral is slightly lower amidst soft earnings performance. The combination of these means the probability of breaching a Loss Absorbing Trigger Event is arguably higher. However, we still consider the probability of such an event to be remote (albeit higher than the major banks). The loss absorbing terms make the risk profile of this security asymmetric (large downside but limited upside) and its performance will have a higher correlation to equities than traditional fixed income instruments, especially during a period of stress. The performance of this security will be linked to the probability that the issuer will breach the minimum capital requirement and approach non-viability in the eyes of the regulator (Loss Absorbing Trigger Event). Our valuation assumptions are based on the security being redeemed on the first optional call date (15 August 2024) and all interest payments being made in a timely manner. If this security is not called on this date (extension risk), the price of the security may drop significantly. From a structural perspective, these notes are floating rate meaning they have limited sensitivity to changes in the benchmark yield curve. We recommend investors Subscribe to this issuance. Positive / Negative Risk Factors What factors would change the Recommendation UP The domestic regulator (APRA) continues to implement strict controls over domestic banks. The Liquidity Coverage Ratio became enforceable on the 1st of January 2015 and the Net Stable Funding Ratio will commence on the 1st of January These measures will significantly improve the transparency of risks, in addition to capital, to investors. BOQ has a moderate loss absorption cushion through earnings, capital and provisioning which are the primary defences of the bank to loan and security impairments. We note it is not required to hold the 1% D-SIB surcharge to common equity as Australia s major banks are. In July 2017, APRA released an information paper detailing its anticipated unquestionably strong capital requirements. This landmark announcement was less restrictive than widely feared and means that for non-majors (i.e. Authorised Deposit-Taking Institutions (ADIs) using a Standardised Approach to credit risk), the minimum capital requirement will increase by 0.50% to 7.50%. Affected banks (including BOQ) are expected to be compliant by Consequently, this should widen the common equity capital buffer which is be the first line of defence in periods of adversity and bolsters the framework s protective capacity for Tier 1 and Tier 2 capital investors. In 2016, APRA announced a change to capital adequacy requirements for banks that have adopted the advanced approach for modelling credit risk. This resulted in an increase to the average risk weights for residential mortgages to at least 25%. It is anticipated that this might rise further to 30%. The increase in risk weights is a positive for all holders of bank capital instruments as it increases the buffer against unexpected losses in mortgage portfolios and in APRAs mind improves financial stability of the system. As of 1st July 2016, the major banks have complied with this rule and any further increases to risk weights should help create a more even playing field for BOQ to originate mortgage products. The acquisitions of Investec Finance and Leasing businesses (renamed BOQ Specialist) and Virgin Money have provided further portfolio diversification and new avenues for future loan growth. We believe the acquisitions have been successful and they have been credit positive for BOQ. Through its recent acquisitions and broker expansion strategy, BOQ has improved its geographical diversification outside of Queensland both in term of lending and physical footprint. Any similar purchases would likely also be viewed positively. The bank s strong credit quality of the loan book and capital buffers award it enough headroom to focus on increasing volumes without breaching APRA s requirements. What factors would change the Recommendation DOWN This security includes the Loss Absorbing Trigger Event terminology. If breached, investors are at risk of substantial capital losses. A sharp deterioration in earnings as a result of fraud or risk mismanagement could adversely affect the loss absorption cushion of the group and result in an event whereby conversion (or write-down) is triggered. We view this as an unlikely but possible event. Distributions on this security are discretionary and subject to payment conditions. The primary risk here is that the minimum Common Equity Tier 1 Ratio (CET1) (inclusive of capital conservation buffers) expected by APRA will increase to 7.50%. If BOQ is unable to maintain its CET1 ratio to a level above the minimum requirements, interest payments may not be able to be made. This ensures BOQ is complying with APRA s capital adequacy requirements. This is partially mitigated by internal capital targets (CET1 of %) and distribution restrictions. Our analysis suggests that most banks will need higher core (and total) Tier 1 capital ratios, especially if the minimum risk weighting on residential mortgages will increase once more or if additional capital is required for investor lending. This change would also require an increase in supply of additional Tier 1 securities, which could potentially put pressure on credit spreads for existing securities. 22 November 2017 Page 2

3 In 2007, a BOQ proposed merger with Bendigo Bank was rejected due to different business models and philosophies. The concept behind the merger was sound but it also brings to light the risks in a change of control scenario. A Potential Acquisition Event gives the issuer the option to convert all of the capital notes into ordinary shares but an Acquisition Event forces the conversion. Such consolidation by regional banks could still occur in Australia. BOQ (as well as other regional banks) have arguably been operating in an uneven regulatory framework (in terms of capital required against residential mortgages) as they are not approved to use internal ratings based models (with lower capital requirements) like the majors (and Macquarie). This means they have been at a pricing or risk disadvantage when writing new loans. This weakness is in part mitigated by the changes to capital requirements described above. Issuer Outlook - Stable as at 22 November 2017 Earnings On the 12th of October 2017, BOQ delivered strong results for the financial year of 2017 (FY17) with the second half outperforming the first. The bank reported a Statutory Net Profit after Tax (NPAT) of $352 million, up 4% from the prior corresponding period (pcp) FY16. Cash earnings after tax grew by 5% to $378 million from $360 million in FY16, including a $16 million profit on the disposal of a vendor finance entity. Additionally, impairment expense decreased to $48 million, almost 30% less than the $67 million recorded in FY16. BOQ s lending growth returned to positive (from a 1% contraction in 1H17) with Gross Loans and Advances (GLAs) rising by 2% to $43.82 billion from FY16. The lending book performance was largely attributed to the bank s niche businesses consisting of commercial mortgages (6% up) and BOQ Finance (5% up) but was slightly offset by a reduction of 0.12% in housing lending. For the year, net interest margin (NIM) fell 0.07% to 1.87% due to challenging market dynamics, including a lower yield curve and higher funding costs. We do note that margins improved 0.05% to 1.90% in 2H17, signalling a better path ahead. BOQ s strategy not to chase loan growth at the expense of asset quality continued to drive benefits on the expense side. The aforementioned impairment decreases drove a marginal improvement in the cost to income ratio, which, at 46.6% was 0.2% less than FY16. APRA s tighter lending standards and cap on growth in the investor portfolio adversely impacted the bank, as management stated that the bank could not compete efficiently with its bigger rivals. In contrast, the bank s lending volumes have been picking up through diversified channels and its niche arms are expected to be key drivers for future earnings. Capital As at 31 August 2017, BOQ reported a very robust capital position with Common Equity Tier 1 Capital ratio (CET1) and Total Capital Adequacy Ratio (CAR) at 9.39% and 12.37%, up 0.39% and 0.08% over FY16 respectively, providing significant buffers over the (current) CET 1 regulatory minimum of 7.00% and at the higher end of the bank s own internal target range (8.0% - 9.5%). This is also well above the 8.5% expected of standardised banks from APRA s July unquestionably strong announcement. As management indicated, the bank will likely see a further rise of 0.20% to 0.25% in CET1 going forward in 1H18. Given the above strength, the bank announced an 8 cents special dividend, maintained its final dividend at 38 cents and interestingly suspended its reinvestment plan for just this period. These actions lifted the payout ratio to 84% (vs 76% in FY16), which may appear credit negative to some, but we do not expect it to have any material impact on BOQ s credit profile given its adequate capital buffer. Overall, with sufficient capital reserves, the bank remains conservatively positioned relative to peers and management has indicated that the bank is well positioned for the upcoming potential Basel IV reforms. Asset Quality With management s strategic decision to prioritise asset quality over growth, loan impairment expenses decreased by 28% to $48 million in FY17 and stood at 0.11% of GLAs. Actual impaired assets fell 17% to $192 million, representing 0.44% of GLAs. While the group has historically been concentrated in Queensland due to its branch network and grass-root client base, its broker expansion strategy has accelerated both geographic and demographic diversification. Overall, although there were pockets of weakness across the economy, these have not impacted BOQ s loan portfolio and for now we remain comfortable with the asset quality of the issuer. Funding and Liquidity The group s funding mix improved slightly with deposit funding as a percentage of loans reported at 69% as at 31 August 2017 (up 1% on pcp). As BOQ s primary means of wholesale funding (19% of funding profile), the amount generated via securitisation increased to $4.2 billion from $4.1 billion in FY16 following a $0.2 billion decrease in 1H17. As at 31 August 2017, BOQ s Liquidity Coverage Ratio (LCR) was 132% (average over the quarter was 133%) and remains well above the 100% LCR requirement by APRA. In addition, the Net Stable Funding Ratio (NSFR) was 107%, indicating sufficient buffers over APRA s 100% NSFR requirement effective 1 January From a liquidity perspective, the bank has significantly increased its liquid asset portfolio over recent years and will receive support from the RBA in terms of contingent liquidity. Importantly, customer deposits grew by $640 million and $200 million of long-term wholesale debt was issued over the year, helping the group become less reliant on short-term wholesale funding. Outlook The regulatory environment has changed rapidly over the past few years and the second tier banks are starting to benefit from these changes. 22 November 2017 Page 3

4 We believe there is some way to go before we see an organic increase in NIM as we expect persistent regulatory demands, funding cost pressures and competition for new loans to be significant headwinds. While there is no real reason for concern, there is no real justification for significantly improved earnings until the dust settles on the current round of capital adequacy changes. Overall, the earnings outlook should be stable in the short term and robust organic lending with good underwriting quality along with enough capital headroom offer the bank stability from a credit perspective, while it awaits a more even loan origination framework (i.e. increased capital requirements on major banks should reduce price competition). Next Event: BOQ first half (1H18) Result Announcement on 26th of April November 2017 Page 4

5 Figure 3: Credit Curve (Comparable Securities) 2 Figure 4: Historical Trading Margins of Comparable Securities 1 The balance sheet structure diagram represents a measure of liabilities and captial in order of seniority of the overall cash balance sheet. 2 Pricing as at close of business 21 November 2017 Source: BondAdviser 22 November 2017 Page 5

6 AUD Millions AUD millions Research Report Hybrid Commentary Since 2013, and in line with the regulatory framework that governs the Australian banking system, non-major banks have increased their hybrid issuance (Figure 5). This new issuance marks BOQ s second in this time frame. After the proposed BOQPE is complete, it will extend its maturity profile (Figure 6) by another ~6.6 years, supporting its capital structure and operations. We note that most ADIs in Australia are lengthening the tenors of their issuances. Coupled with low expected asset growth in the near future, it may be some time before Bank of Queensland offers investors a new Additional Tier 1 security. A relatively low-growth environment in Australia and New Zealand is expected over the next few years with the housing market likely to slow down and soften both naturally and as a result of regulatory actions and limits. Under current regulatory settings, we believe that BOQ is in a strong capital position. Figure 5. Non-major Bank Listed Hybrid Issuance (Assuming BOQPE issuance amount of [$300m]) 1,800 1,600 1,400 1,200 SUNPD BOQPE 1, SUNPC SUNPE MQGPB SUNPG BOQPD MQGPA MBLPA BENPF BENPG 200 BENPD AMPHA BENPE AMPPA SUNPF Source: BondAdviser Figure 6. Non-major Bank Listed Hybrid Maturity Profile (Assuming BOQPE issuance amount of [$300m]) 2,500 2,000 1,500 SUNPD 1,000 MQGPA SUNPE BOQPE SUNPF SUNPC BOQPD MBLPA BENPF SUNPG MQGPB BENPD AMPHA BENPE AMPPA BENPG Source: BondAdviser 22 November 2017 Page 6

7 Average Trading Margin Trading Margin Research Report BOQ s only existing ASX-listed hybrid (BOQPD) has been trading on a range bound basis and generally between 3.0% and 5.0% since 2012 (Figure 7). It has dropped to and oscillated around the 1.0% mark since late-september 2017 though, mainly as a result of the security approaching its expected redemption date of 15 April 2018 as investors have purchased it in volume on the open market in order to achieve a reinvestment allocation of this BOQPE offer. The proposed margin range of [3.75% %] sits within BOQ s historical average valuation range. We view it as at fair value consistent in relation to BOQ s own credit curve across the term structure. Figure 7. BOQ Listed Hybrid Historical Trading Margin (BOQPD) 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Jun 15 Dec 15 Jun 16 Dec 16 Jun 17 Source: BondAdviser Figure 8. Non-major Bank Listed Hybrid Average Trading Margin 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Oct 08 Oct 09 Oct 10 Oct 11 Oct 12 Oct 13 Oct 14 Oct 15 Oct 16 Oct 17 We view the indicative margin range of [3.75% %] as being commensurate on a relative value basis (Figure 8). Bendigo and Adelaide Bank s most recent 6.5-year AT1 offer, BENPG, has been priced at 3.75% and Suncorp Group s recent 6.5-year AT1 offer, SUNPG has been priced at 3.65%. In both occasions, the final pricing was at the lower end of the guidance range. Similarly, we expect BOQPE to eventually price at the lower end of the guidance range being 3.75% (Assumed in Figure 9). 22 November 2017 Page 7

8 Trading Margins Research Report Figure 9. Non-major Bank Listed Hybrid Trading Margin 4.00% 3.50% 3.00% 2.50% MQGPB, 3.63% BENPF, 3.27% BENPE, 3.01% SUNPE, 2.69% AMPPA, 3.08% MBLPA, 2.55% SUNPF, 3.14% BENPG, 3.75% SUNPG, 3.65% BOQPE, 3.75% 2.00% MQGPA, 1.72% 1.50% 1.00% AMPHA, 1.41% SUNPD, 0.84% 0.50% BOQPD, 0.60% 0.00% Term to Expected Maturity (Years) Source: BondAdviser (pricing as at close of business 21 st November 2017 and assuming issue margin of 3.75% for BOQPE) 22 November 2017 Page 8

9 Bank of Queensland Limited: Financial Summary Bank of Queensland Limited: Financial Summary Recommendation Summary Subscribe 22 November 2017 Profit and loss Net Interest Income ($m) Other Operating Income ($m) Net banking operating income 1, , , Net insurance operating Total Income ($m) 1, , , Operating Expenses ($m) Loan Impairment Expense Profit before Tax ($m) Income Tax Expense ($m) Statutory Net Profit After Tax Capital Adequecy Regulatory Reporting Common Equity Tier 1 ($m) 2, , , , ,861.0 Additional Tier 1($m) Tier 2 Capital ($m) Total Capital ($m) 3, , , , ,638.0 Total On-Balance Sheet Assets 25, , , ,135. Securitisation Exposures ($m) Market Risk ($m) Operational Risk ($m) 2, , , , ,878.0 Total Risk Weighted Assets 28, , , , ,552. CET 1 Ratio (%) Total Capital Ratio (%) Balance Sheet Cash and Interbank Assets , , , Loans and Advances ($m) 43, , , , ,989. Investment Securites ($m) 3, , , , ,067.0 Trading Asset Securities ($m) 1, , , , ,595.0 Intangible Assets ($m) Other ($m) Total Assets ($m) 51, , , , ,528. Interbank Liablities Deposits ($m) 37, , , , ,699. Payables and other liabilties Borrowings including 9, , , , ,137.0 Other ($m) Total Liabilties($m) 47, , , , ,711. Bank Ratios Note: GLA = Gross Loans and Lending Growth (%) Net Interest Margin (%) Cost to Income Ratio (%) Deposit to Loan Ratio (%) Impaired Assets to GLA (%) Loan Book Residential Mortgage Loans 29, , , , ,149. Personal Loans ($m) Overdrafts ($m) Commercial Loans ($m) 9, , , , ,079.0 Credit cards ($m) Leasing finance ($m) 4, , , , ,910.0 Gross Loans and Advances 44, , , , ,706. Unearned lease finance Provision for Impairment Total loans and advances 43, , , , ,989. Asset Quality Retail Lending ($m) Commercial Lending ($m) BOQ Finance ($m) Total Impaired Assets ($m) Specific provision ($m) Specific Provisions/ Impaired Total Provisions and GRCL to Funding & Liquidity Source: Company data, BondAdviser estimates. 22 November 2017 Page 9

10 Research Methodology Every research report prepared by BondAdviser includes a clear recommendation - Buy, Hold or Sell - on the security. This recommendation framework is designed to help investors navigate different investment opportunities by identifying the market price, yield, term to maturity, liquidity, volatility and risk. The guide below may help you understand our research opinions. For further information on our research approach, you can refer to our RG79 statement by clicking here. Research Opinions key Buy - Over the next 12 months, the analyst expects the security to outperform the current yield due to credit spread tightening or favourable movements in the underlying yield curve. Hold - Over the next 12 months, the analyst expects the security to provide stable returns broadly inline with the current yield but with little credit spread tightening. Sell - Over the next 12 months, the analyst expects the security to underperform the current yield due to credit spread widening or adverse movements in the underlying yield curve. Suspended - The recommendation has been suspended temporarily due to the disclosure of new information or market events that may have a significant impact on our recommendation. This also includes situations where we have been given non-public information and we need to temporarily suspend our coverage in order to comply with applicable regulations and/or internal policies. Not Rated - A security that has not been assigned a formal recommendation. Analyst Simon Fletcher Credit Research simon.fletcher@bondadviser.com.au About BondAdviser BondAdviser is an independent research company that specialises in bonds and fixed income securities. We provide investors, advisers, brokers and institutions with research, data, education and tools to help them invest intelligently. 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