ANZ sets worrying hybrids precedent

ANZ has sent a shiver down the spines of all retail hybrids investors by deferring an issue redemption.

Summary: Retail investors in an ANZ Bank issue of hybrid notes launched in 2008 hoping the bank would pay them out after five years have been advised that the issue will run for another five years. What’s more, the coupon rate that has been reset for the next five years is considerably less than investors were earning over the first five. The move could set a precedent for other hybrid investors.
Key take-out: Investors who bought hybrid notes issued by some of Australia’s largest companies may have to wait between 25 and 60 years before their investments are redeemed.
Key beneficiaries: General investors. Category: Income.

At the end of the week before last, the New Zealand subsidiary of ANZ Bank advised the mostly retail investors who had bought its $NZ835 million of Tier 1 hybrid notes issued in April 2008 that it will not be calling the notes as expected.

The notes will be allowed to run for another five years, at the end of which time a coupon step-up will come into effect if the notes are not called.

ANZ said that while it had the option to redeem the notes after five years, it had never intended to do so. With the coupon step-up built into the structure of the notes not coming into effect until 10 years after issuance, it had no economic incentive to redeem earlier.

In fact, ANZ will now be better off in more ways than one.

The bank had been paying a coupon of 9.66% per annum, which was determined at the time of issue by applying a 2% margin to the five-year swap rate. The coupon will reset in April this year to 2% over the current five-year swap rate, which if applied today would result in a coupon of around 5.5% per annum.

Moreover, if the bank had to re-issue the notes now in a Basel III compliant form, the credit spread would be around 3.2%, rather than 2%.

Understandably, this has left investors with a nasty taste in their mouths.

Moreover, the precedent set by ANZ has implications for Australian investors holding ANZ’s CPS3 notes, issued here in September 2011, and all locally issued hybrids notes since.

Among the major banks, the CPS3, Commonwealth Bank’s PERLS VI, NAB Capital Notes and Westpac’s CPS all have call dates effective six years after issue. However, there is no coupon step-up as this is prohibited under Basel III.

Fortunately though, each of these issues provide for mandatory conversion into the ordinary equity of the issuer two years later if the notes have not been called. Given the dilutionary impact this is likely to have, the banks have an economic incentive to call the notes on the call date, assuming all is well at that time.

The investors who bought the hybrid notes issued by some of Australia’s largest companies last year have more to worry about. There is little economic incentive in those issues for the notes to be called at the first call date, which would leave investors with 25-year to 60-year investments.

For example, the notes issued by Caltex and Tabcorp have 25-year terms to maturity and call dates five years after issuance. If the notes are called at this time, the coupons will step-up by just 0.25% per annum.

One could argue that an increase in the coupon rate of 0.25% is neither here nor there, if another 20 years of funding is available.

Investors in the APA and Crown notes should be even more concerned. While the first call date for the notes kicks in five years after issue, there is no coupon step-up until 25 years later.

At that time the coupon will increase by 1% per annum. But again, what economic incentive to redeem does a 1% increase in the coupon rate provide, when a further 35 years of funding is available?

Of more concern, however, is the fact that these notes were sold to investors on the basis that they would be redeemed on the first call date, five years after issue, even though there is no coupon step-up at that time. The economic incentive to redeem would come from a change in the ‘equity credit’ the notes attract for the issuer from a major credit rating agency.

How important this equity credit is to an issuer in five years’ time will depend on the credit quality of the issuer at that point. Furthermore, the rating agency concerned is already reviewing its criteria for granting equity credit and the proposed changes, if implemented, will likely strip the issuers of the equity credit obtained from the notes immediately.

If this occurs, and the issuers do not redeem the notes at the time the equity credit is lost, there will be no incentive to call the notes on the first call date, unless the notes appear expensive relative to market interest rates at the time.

This raises a question of whether these hybrid notes were mis-sold to investors? Were investors misled on the prospects for redemption after five years?

We note that retail investors in Spain are considering suing their local banks (or anyone with deep pockets associated with the issues) for the mis-selling of hybrid notes.

The circumstances are a little different, as the hybrid notes concerned have converted to equity or been written-off, as the Spanish banks ran into financial difficulties. But the principle is the same – investors were misled.

The sales pitch emphasised the security of the issuing bank and not the real risks attached to the hybrid notes.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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