Avoid Westpac and NAB Capital Notes

The latest round of one-sided hybrid bets is here. Don't get sucked into Westpac Capital Notes 4 and NAB Capital Notes 2.

If you’re considering the Westpac Capital Notes 4 or NAB Capital Notes 2 offers, take a moment to consider whose welfare management has in mind.

The golden rule for any board of directors is that it must act in the best interest of the company’s common shareholders. By law, a bank’s management cannot issue securities that don’t benefit the shareholders – and what’s good for them usually isn’t great for other securityholders higher up in the capital structure.

Make no mistake: hybrid securities were invented to reduce the bank’s financing costs and risk, not to make you rich.

The 4.9–5.1% margin that both Westpac (ASX: WBC) and NAB (ASX: NAB) are offering above the bank bill rate (currently 1.99%) looks attractive relative to what you are getting on cash and better than most recent hybrid issues. Nonetheless, it’s still poor compensation for the risk.

Hybrids aren’t guaranteed by the Government so aren’t in the same league as savings accounts and term deposits. The prospectus isn’t joking when it says ‘If NAB Capital Notes 2 are written off, holders will not have their capital repaid 
and will not be entitled to any return in a winding up.’

What’s more, the Notes rank below senior bonds and so distributions are only paid ‘if the Directors in their sole discretion resolve to pay the relevant distribution’. You can imagine their enthusiasm to do so at the first sign of trouble. 

Another shortcoming is that the Westpac and NAB Notes are perpetual and without a fixed maturity date. You may never receive your capital back or have them converted to ordinary shares, which would at least allow you to participate in any increase in the bank’s profitability and see capital gains.

In fact, the only time the Notes are likely to convert is if Westpac or NAB breach various solvency ratios. So right when the banks are having financial difficulties – and their share prices undoubtedly collapsing – you would be converted to an ordinary shareholder and no longer receive any seniority in a wind up.

As research director James Carlisle explained in Don’t bank on hybrids, investors who are determined to get the yield on offer could do just as well buying a smaller position in the ordinary bank shares and putting the rest in cash.

Using the NAB Capital Notes 2 as an example, if we assume a margin of 4.95% above the 1.99% bank rate, you get a gross yield of 6.94%. However, you could match that with a portfolio of 48% cash in an NAB term deposit, earning 3%, and 52% in NAB shares, with its gross dividend yield of 10.57%. The cash would limit your losses in a disaster scenario, while the stock would let you participate in any long-term increases in NAB’s profitability and subsequent dividend growth.

To be sure, chasing a specific yield isn’t the best way to make investments and there are better risk-adjusted opportunities on our current Buy list. But the moral remains: if a banker emails you a 136-page prospectus, there’s more to the story than an attractive yield. 

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