Summary: Considerable press has recently been given to the suitability, risks and price movements of bank hybrids, but this is worth putting into context. Although capital notes contain trigger conditions, potential capital losses would only be a factor in extreme circumstances. Recent price falls can be explained by market indigestion and rotation into cheaper equities after the sell-off. And shares have a higher dividend now, but this is not always the case.
Key take-out: Investors who understand the importance of a diversified portfolio should not be fazed by recent press around hybrids.
Key beneficiaries: General investors. Category: Hybrid securities.
The Australian Securities and Investments Commission (ASIC) has been at pains to point out to investors that (bank) hybrids are complex. Yes, like all financial instruments there is a degree of complexity in terms of the legal framework and operation of these securities. This is especially evident in the case of bank issued Capital Notes or Convertible Preference Shares. The reason is simple: the industry regulator (APRA) requires that these securities contain certain features so that they meet the global (Basel III) standard for inclusion as bank capital. This is important because bank capital, no matter its technical name (there are various types), is what supports a bank’s business activities and ultimately its depositors.
ASIC is right to make sure that investors have full information and understand the risks of this and indeed every other investment. Education is crucial.
There has been considerable press recently focussing on bank hybrids, specifically their suitability, the risks and price movements. It is worth putting some of these comments into context.
Capital Notes contain capital trigger and non-viability conditions – this will see investors lose their money.
The first part of this statement is correct; they do contain these conditions as required by APRA and the Basel III rules. However, potential losses of capital (under a capital trigger event) will only be a factor if the issuer cannot raise new capital and the issuer’s ordinary share price has fallen by more than 80% from the time the securities were issued. It is only below this level that in the event of conversion, holders would receive less than $101 worth of shares as the maximum conversion feature comes into play. At any point above this level, investors will receive $101 of shares for each Note exchanged.
Non-viability, while not strictly defined by APRA, is clearly another extreme outcome and would include circumstances where a bank is unable to access credit or capital markets. We would note though that many banks carry large liquidity buffers to avoid against such extreme outcomes. Macquarie Bank, for example, highlighted recently that it maintains the equivalent of 12 months of funding in liquidity to protect against such events. Post the GFC the RBA has also established multiple facilities that will allow banks to access funding should that be required. It is only after these and other safeguards have failed, markets have shut and the Notes can’t be converted into shares, that the Notes would be written-off. It is not obvious what could lead to such an extreme set of circumstances occurring but remember that even in the GFC, Australian banks were still able to access capital markets and the ASX along with its ancillary support structures continued to operate.
The UK has placed a ban on the sale of bank Tier 1 (Capital Notes) to retail investors.
Yes it has, but there are material differences in the risk profile of the banks in Australia and the UK. CBA for example has a Common Equity Tier 1 capital ratio of ~9.3% under APRA rules. Under harmonised global measures i.e. the same basis upon which UK and European banks are assessed, this ratio is over 12.0%; this is a material difference. We know that APRA is a much tougher regulator than its global peers and banks here are generally in a much healthier state. In fact, if you reverse the explanation, you can easily understand why the UK regulator might be concerned. Let’s say for example, that a UK bank has a capital ratio of 9.0% calculated on a harmonised basis, if we measured that same bank’s capital position under APRA’s rules, this would show a capital ratio of circa 6.0%. Given that capital trigger conversion conditions kick in at 5.125% ... well, you can see the point.
Comparing the Australian and UK situation is not apples and apples. Australian investors are being offered a very different risk/reward proposition to what might be offered to UK investors.
Shares have a higher dividend.
Yes they do at present, but of course this is not always the case. Shares are lower ranking and potentially much more volatile. Simply, they are growth investments; it comes down to what investors are looking for, growth or income as well as their investment timeline. It might well be that a mix of the two is even appropriate.
Ordinary equity is too expensive to issue, that’s the only reason banks issue hybrids.
These instruments have met the needs of both the issuers and investors. It is obviously a cost effective source of funding for the banks while hybrids deliver franked income to investors – many people would regard this as a win-win.
Hybrids have no maturity date.
Correct, but they have a mandatory exchange date subject to conversion conditions. Further, they are callable two years prior to that date and a bank will be very conscious of the implications of not exercising this early redemption.
Banks would be very mindful of how such inaction would be interpreted by capital markets globally and indeed how it might then impact their ability to raise new capital of any type from those markets.
Hybrid distributions are discretionary and non-cumulative.
There exists in all these structures a dividend stopper feature which should give holders confidence that they will receive their distributions as expected. If the issuer does not pay a hybrid distribution then it is not able to pay ordinary share dividends or distribute other capital in the ensuing period. In the Australian context where banks have always acknowledged and understood investors’ desire for regular and predictable dividends, banks would be very mindful of the implications of not paying dividends on either hybrids or ordinary shares.
Investors are at risk if the bank's capital position falls to 5.125%.
Remember, conversion risks only kick in after an 80% fall in the issuer’s share price. Also and importantly, banks manage to much higher levels of capital and will be protecting the 8.0% APRA minimum requirement, not 5.125%; i.e. they will be issuing equity a long time before a trigger event is in reach.
There have been some very direct and public recommendations to sell your hybrids and invest in Government or corporate bonds.
It may well be the best thing for some depending on their circumstances.
Government bonds should be a consideration for all investors but remember debt instruments also carry risk and you need to understand what those risks are. In the case of Government bonds you know that the Government will always be there to repay the face value (but not what you paid). You should understand that they are fixed rate investments and expose holders to interest rate risk which means that as interest rates rise, the capital value of the bond will fall. Many investors do not understand that if you own a 10 year bond today and the yield on the instrument rises by just 1.00% (which is possible, in fact some say is very likely) then the value of that bond will fall by over 8.00%; for inflation linked bonds this capital sensitivity to higher yields is even higher.
If you invest in a corporate bond you should understand very clearly the quality and balance sheet strength of the issuer. Do not assume for one minute that just because it is called a senior bond that it is safe. Not all issuers are equal and not all bonds rank equally; they may not be as senior as you think with many structurally subordinated to other lenders e.g. the banks.
You need to understand the cost of trading and the liquidity available to you if you need to sell. Like hybrids, you must understand what you invest in and importantly, always diversify your portfolio.
A very important development for investors is underway at ASX and ASIC. In the not too distant future, retail investors will be able to invest in the same high quality corporate bonds currently only available to institutional investors and they will be ASX listed. These bonds are issued by some of the largest companies in Australia and will trade in the same manner as ASX listed Government bonds do now. This means that you can view, trade and hold your bonds in the same way as you do shares. To understand more about this process please read Morgans’ Government bond publication; Morgans will also publish more information in the period ahead about this new ASX corporate bond market.
Recent price moves just show how risky hybrids are.
Well perhaps not; it looks to me that the sell-off can be explained quite simply by a range of factors;
- market indigestion – there has been circa $4 billion of hybrid securities come to market in the last month or so;
- rotation back into cheaper equities after the sell-off;
- the significant upswing in equity capital raisings that has seen investors need to raise cash (by selling hybrids) to fund these new opportunities.
Many expect that once we move through this period, the natural flow of new money looking for a home will see a more orderly market and hybrid price levels correct.
So, is it all doom and gloom? Of course not; investors who remember the importance of a well diversified portfolio should not be fazed by the recent press or market weakness. Diversified portfolios do survive volatility and even in times of extreme stress, they do come out the other side intact.
The rules of investing have not changed; if you want a return on your money then you must take some risk. If you don’t want to take any risk, then simply invest no more than $250,000 in a term deposit and sleep well knowing that the Government is there to protect you. However, if you require higher levels of income, then seek appropriate advice and build a diversified portfolio. Of course, it may or may not include hybrids, depending on your specific needs.
Make sure you understand the facts, and do what is right for you and your circumstances.
Steven Wright is director of fixed interest at Morgans Financial. This is an edited version of an article which first appeared in Morgans' Listed Credit Australia publication and represents Morgans' views and may not represent the views of Eureka Report.