PORTFOLIO POINT: Bank hybrids may look attractive, but there are some over-the-counter bonds that are just as competitive.
ASX-listed bank hybrids often look attractive, and some investment groups have 'buy’ recommendations on all of them. However, if you look beneath the surface of a major bank paying an attractive return, you’ll find some big differences in the level of risk you’re being asked to assume. In many cases, you can beat the bank hybrids in terms of risk or return if you consider investing in over-the-counter (OTC) markets.
There has been a lot of press regarding hybrids over the last few weeks. As a fixed income analyst, I’m looking for good relative value given the risks involved. So when I analyse a hybrid, or any security for that matter, I’m asking myself a couple of questions:
1. Am I confident in the underlying credit quality of the issuer? That is, do I expect them to be able to trade throughout the cycle and meet all their interest and principal repayments when due?
2. Where does the security sit in the capital structure? Understanding the capital structure is very important. We’ve found some hybrids rank as equity in a wind-up, so in effect are equity without any potential upside (Time to review CBA Perls).
3. What are the returns other securities are earning in the capital structure? Or for that matter, similar level credit issuers’ securities across the capital structure? Which level offers the best return for the risk involved?
You’ll note that there are two main elements of my assessment: risk and, of course, return. Too often investors concentrate on return, when really you need to assess both elements. If I’m assessing hybrids, I’ve got another list of questions:
1. Are the distributions cumulative or non-cumulative? Cumulative means that if for any reason distributions are missed, they’ll be made up at a later date. Non-cumulative means there is no requirement to be made up and these securities are much more 'equity-like’ than 'debt-like’. As a result, I’d want a higher return for non-cumulative hybrids to compensate. Many of the recent corporate hybrids are cumulative, but as a general rule bank hybrids must be non-cumulative, to meet APRA requirements.
2. What are the repayment/ conversion options and are they my options or the issuer’s options? A set conversion date to the underlying share is much more 'equity-like’ compared to an option of repayment of capital or conversion at the investor’s discretion. The straight conversion to equity should, in my opinion, come with a higher distribution or interest payment. While there will usually be minimum conversion terms, there is no defined maturity and to recoup your capital, you need to decide to sell the shares.
3. Is there a step-up for non call? These are the older type of hybrids and under Basel III, there are additional incentives for the banks to call these at the first opportunity, meaning investors get their capital back. I’d deem these more 'debt-like’, so be happy with a lower distribution over the non-cumulative mandatory conversion to equity securities, discussed above.
4. Is there a loss of equity treatment by the credit rating agencies if not called at the first opportunity? If so, there’s added incentive to call or repay the investor, so considered more “debt like”.
5. Is there a common equity trigger event? The new breeds of bank hybrids have mandatory conversion clauses to help rebuild capital in times of stress. For example, the ANZ CPS has a trigger to convert to equity (with haircuts to the original principal) should the Common Equity Capital ratio be equal to or lower than 5.125%. These hybrids should pay higher coupons to investors due to the mandatory conversion to equity clause.
Basel III, the new set of global regulations for banks, is driving the new bank hybrids so it’s worth recapping some of the regime’s key themes.
New global banking regulation known as Basel III will have significant consequences for the sector, which we’ve already begun to witness:
- A requirement for a higher level of Tier 1 capital, including hybrids which must also be higher quality (meaning loss absorbing). The favoured type of Tier 1 capital by regulators is common equity or anything that is more equity-like.
- Higher and better liquidity levels, essentially devoting a higher proportion of assets to very high quality liquid assets. In Australia, this means Commonwealth government bonds, which currently yield around 4%. Generally this will mean banks will have less available capital to lend at higher levels and it will impact profitability
- Securities that sit high in the capital structure will be better supported by the lower-ranking equity capital (Tier 1) securities, but the Tier 1 securities or hybrids will be much more equity-like, designed to absorb losses
- Higher costs for banks in terms of systems and staff needed to oversee Basel III implementation and ongoing oversight
- Requirement for loss-sharing in new hybrid structures, such as automatic conversion to equity (at a loss/haircut) detailed above for the ANZ CPS, should the common equity capital ratio be equal to or lower than 5.125%.
The implication for the new bank hybrids is that many will be designed to meet Basel III requirements and will be much more equity-like. This means that as an investor, you should be paid more for the risk you are undertaking – but you’ll need to make that risk/reward assessment. If you can invest in securities that sit high in the capital structure, which are safer and are being paid similar or only slightly lower returns, you can improve the risk profile of your portfolio without substantially impacting return.
Below is a list of over-the-counter bonds, which offer high returns for much lower risk or higher returns for an equivalent risk. Note that the securities listed in black are available to both retail and wholesale investors (those in red are available to wholesale investors only).
The senior debt bonds listed above have known coupon payments until maturity, when you are assured of capital repayment unless the issuer goes into wind-up, which we think is very unlikely. That certainty of income and capital means the securities are much lower risk and should therefore pay much lower coupons. The Societe Generale senior bond is a stand-out, offering 8% yield to maturity, with only 2.5 years until investors can expect full repayment.
The Morgan Stanley bond is also very good value, when you consider it is senior bank debt, again with a known maturity date. If you compare it to the three equity-like, ASX-listed hybrids in the table below (MBLHB, NABHA and SPKHB), your return is marginally lower but you have the benefit of a known maturity date with capital returned to you. In contrast, the three equity-like hybrids are deemed “true perpetuals” and we think the banks are unlikely to repay those securities until they can refinance at cheaper margins than the 1.70%, 1.25% and 0.75% margins at which they were respectively issued.
Included on the list are some debt-like over-the-counter bonds, showing comparable or higher returns. One of our current favourites is the Swiss RE Tier 1, showing a yield to first call of over 11%. Swiss Re has the same issuer credit rating as Australia’s major banks and has a history of repaying securities at first call. So, we think the return is excellent relative value given the risk involved.
Defining the risk between senior debt and hybrid securities - The Fitch Credit Rating Agency review of listed bank hybrids
Credit rating agency Fitch recently reviewed their listed bank hybrids in Australia and re-rated them so that they are five notches lower than the rating of the banks’ senior debt. In effect, the rating agency sees the level of risk of the hybrids as being five notches more 'risky’ than that of the senior debt in the same bank.
Five notches is quite a large 'risk’ gap from one security to another. However, the five notches reflects Fitch’s view of the increased risk in these securities. So how do they arrive at the five notches? The five notches 'consists’ of two notches for loss severity and three notches for risk of non-performance.
What is loss severity? As the phrase suggests, it is how severe a loss an investor can expect from the debt instrument in the case of non-performance. Fitch has allocated two notches to loss severity for bank hybrids, which is the maximum number of notches they can apply under their methodology, reflecting a 'poor’ chance of recovery.
This poor chance of recovery reflects the agency’s view that governments are unlikely to provide any support for hybrid holders, something which is being born out in some European jurisdictions where it appears only senior bond holders will be afforded any protection, and reflects the governments’ 'share the pain’ mantra which has been adopted since the government bailouts of financial institutions occurred.
The loss severity notching also reflects the fact that absorbing losses for senior bond holders is exactly what hybrids are designed to do; it is, in effect, their raison d’Ãªtre.
Some investors take comfort in investing in listed bank hybrids, as they see the risk of default for Australian banks as being very low. However, whilst this might be true of older legacy hybrids, new hybrids are designed with meeting the requirements of Basel III in mind.
The three-notch downgrade reflecting 'non-performance’ as applied by Fitch reflects the much lower hurdle of non-performance under Basel III than a 'default’ test. In part, due to this lower hurdle, Fitch views the risk of non-performance of bank hybrids as 'very high’. Fitch noted: “...that the risk of a bank entering into a capital buffer zone is considerably higher than that of hitting the point of non-viability”.
In the Australian context, payment of distributions to hybrid owners is subject to an annual profits test, which Fitch believes to be an easily activated non-performance trigger. While it is a little unclear at what point a regulator will require a bank to interrupt coupons, it would likely arise if a bank entered a capital conservation buffer or regulatory buffer (regardless of whether this was a temporary arrangement).
In conclusion, I’m not suggesting you sell all of your bank hybrids, as I don’t believe any will go into wind-up. Instead, step back and assess them by understanding the underlying terms and conditions and the risks involved. Are you being adequately compensated for those risks? If not, it’s worth investigating over-the-counter options which offer some attractive alternatives.
Note: FIIG Securities provides detailed research to its clients on the bonds listed above. All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.
Elizabeth Moran is director of education and fixed income research at FIIG Securities.