Avoid IAG's Capital Notes
New hybrid securities are rarely a good deal for investors, and this insurer's recent offering is more of the same rubbish.
By law, a company's management has a duty to act in shareholders' best interests. Everything management does, at least in theory, is to make the shareholders richer – and that includes the issuance of all other securities, including hybrids.
Earlier this week, Insurance Australia Group (ASX: IAG) launched a $300m Capital Notes offering. We've long preached against hybrid securities issued by the big four banks (see here, here, here, here, here, here or here) and IAG's Capital Notes are of the same slippery set.
Make no mistake: the company is trying to reduce its own financing costs and exposure to risk, not doing its best to enrich those who buy the Notes.
The 4.7–4.9% margin the Notes offer above the bank bill rate, currently 1.76%, would give a fully franked yield of 4.5% to 4.7% (distribution yield = [margin bank bill rate] x [1 – corporate tax rate]). That's in the region of IAG's fully franked dividend yield of 4.7%.
Nonetheless, it's still inadequate compensation for the risk, which is nicely summarised in the fine print on Page 60 of the prospectus: ‘Although Capital Notes may pay a higher rate of distribution than that on comparable securities … there is a significant risk that Capital Notes holders will lose all or some of their investment should IAG become insolvent.'
Downside > Upside
In theory, the Notes rank ahead of shares should IAG be wound up; the trouble is that the Notes are likely to convert into shares if a ‘Non-Viability Event' occurs, which is basically when the regulator tells the company it doesn't have enough capital. And, as though the Notes weren't knee-deep in risks already, ‘APRA has not provided guidance as to how it would determine non-viability.'
These hybrids have been specifically designed to act like fixed income securities in good times (minimal capital gains), yet behave like equities in bad times (large capital losses). That equation doesn't bode well for investors.
What's more, the prospectus isn't joking when it says ‘Payments of distributions are at the absolute discretion of IAG, which means IAG does not have to pay them'. You can imagine management's enthusiasm to cease distributions at the first sign of trouble.
A final shortcoming is that, unlike senior bonds, the Notes are perpetual and don't have a fixed maturity date. IAG is under no obligation to ever give you your capital back – but the company does retain the option to redeem the Notes in seven years if it finds cheaper financing.
The bottom line is this: ‘The Capital Notes are complex and involve more risks than simple debt or ordinary equity instruments' – a sentence repeated no fewer than five times throughout the prospectus.
As for IAG's ordinary shares, we would love to buy the stock at the right price. Here, though, the equation is different. By owning the shares, you get a similar starting yield and downside to the Capital Notes, but the upside isn't capped. Any growth in the insurer's profitability would likely flow through as either increasing dividends or capital gains.
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