Bank hybrids: What could possibly go wrong?

If you're investing in bank hybrid securities you need to know the risks. Richard Livingston highlights those that could lose you a lot.

Key Points

  • ASX has released a new guide to understanding hybrids
  • Hybrids are at risk, so depositors and senior lenders can sleep at night
  • We highlight the key risks for hybrid investors

We’ve had a lot to say about bank hybrids, but not as a member of the cheer squad. In Capital (or Common Equity Capital) Trigger Event and the Non-viability Trigger Event – explained in more detail in Maximum Conversion Number goes hand in hand with the trigger events. Back in the ‘good old days’ (for investors) hybrids would convert into whatever number of ordinary shares was necessary to pay the investor back. Not any more. Now if a Trigger Event occurs, conversion occurs with a cap on the number of ordinary shares that can be issued. Once the cap is hit, the investor starts losing money.
 

  • Conversion Conditions - The Conversion Conditions apply to the Mandatory Conversion (at ‘maturity’), not early conversion caused by a Trigger Event. Broadly, if the share price of the issuer falls by about half from the Issue Date VWAP (the ordinary share price when the hybrid was issued), the Conversion Conditions aren’t satisfied and conversion won’t occur. Instead the hybrid will remain as a perpetual note or preference share until the Conversion Conditions are met.
     
  • ‘Voluntary’ distributions - Issuers aren’t required to pay distributions on their hybrids, but if they don’t they must stop paying dividends on their ordinary shares. This provision (called a ‘dividend stopper’) is meant to act as a deterrent.
  • The Tier 2 hybrids are less scary since they’re to be repaid in cash at maturity, but there’s still some uncertainty over the payment of distributions (they’re subject to a ‘solvency test’) and investors aren’t allowed to enforce their claim if the issuer doesn’t pay up (see junk bonds. But they also have some hybrid specific risks.

    Unexpected losses

    Not all issuers are the same, but they’re typically all highly leveraged. This means only a small proportion of the issuer’s loan books (or other assets) need to go ‘bad’ for one of the Trigger Events to occur (see VWAP’, in technical jargon) was $33.86 and the terms contain the three Mandatory Conversion Conditions set out in Table 3.

    Table 3: NAB CPS 2 Mandatory Conversion Conditions
    First Mandatory Conversion Condition The VWAP of Ordinary Shares on the 25thBusiness Day before a possible Mandatory Conversion Date must be greater than 56% of the Issue Date VWAP.
    Second Mandatory Conversion Condition The VWAP of Ordinary Shares during the period of 20 Business Days on which trading in Ordinary Shares took place immediately preceding (but not including) a possible Mandatory Conversion Date (‘VWAP Period’) is greater than 50.51% of the Issue Date VWAP.
    Third Mandatory Conversion Condition No Delisting Event (eg NAB being delisted, NAB shares suspended from trading) applies to Ordinary Shares in respect of a possible Mandatory Conversion Date.

    If NAB’s share price fell to $16, and stayed there, the first two conditions would be breached and conversion wouldn’t occur. You’d have to continue holding the preference shares until NAB’s share price recovered to at least $18.96. If it didn’t, selling them on-market (probably for a large loss) would be the only exit route.

    This scenario gets ugly if the same events driving the share price fall also cause NAB to stop dividend payments on the CPS2. In this case, you wouldn’t expect to see much of your original $100 back.

    Lack of interest

    The proliferation of bank hybrids is a function of low interest rates, retail investor appetite for risk and yield and the global boom in junk bonds. Each of these things could easily reverse.

    Stronger economic growth may see interest rates return to more ‘normal’ levels. Higher interest rates, particularly if coupled with decent sharemarket returns, could see investors (who no longer ‘need’ the income) turn away from junk bonds globally and hybrids in our local market. Weakness in hybrid prices could see this process accelerate, making falling prices a self-fulfilling prophesy.

    Of course, this only affects you if you need to sell before the maturity, or mandatory conversion date.

    What else could go wrong with bank hybrids?

    These are the three events which would cause the most significant losses but there’s other things to keep in mind, including:

    1. Non-viability Event Trigger - The banking regulator, APRA, hasn’t clarified what a ‘Non-viability Event’ means. This Trigger Event is completely at their discretion.

      The risk, for those holding the hybrids that contain this trigger, is that APRA may decide a Non-viability Event has occurred long before common sense might suggest.
       
    2. Dividend Cut - Payment of hybrid dividends is optional but they come with the ‘dividend stopper’. It’s said ‘the banks will never stop their dividends’ and, whilst this isn’t quite true, it would be a last resort.

      What’s often missed is that if the banks did cut their ordinary share dividend – whether because of a large loss or difficulties raising capital – they’d almost certainly cut the hybrid dividends as well.

      Why? Well firstly, APRA would probably demand it – to shore up the issuer’s balance sheet. But, even if they didn’t, continued payment of hybrid dividends constitutes a gift from ordinary shareholders at that point, a situation unlikely to be allowed to continue for long.
       
    3. Complexity - Risk increases with complexity, and hybrids have this in spades. In the tonnes of detail it’s possible something doesn’t end up working in the manner expected or an event that today is unexpected – for instance, a tax or regulatory change, or an event causing the hybrids to be written off – ends up happening.

    These are unlikely events, but they’re not impossible and they’re over and above the risks you take with a vanilla debt instrument or bank deposit. It’s why we recommend people think of these new hybrids as low-return equity, rather than high-return debt.

    You also need to think about the relationship between hybrids and the rest of your portfolio. Hybrids are sometimes pitched as ‘providing diversification’ but, if you’re adding bank hybrids to a portfolio of bank shares, you’ve got less diversity.

    Final words

    Hybrids aren’t likely to go bad, but if they do the financial damage could be catastrophic. If you must dance at the hybrid party, limit yourself to an amount you can afford to lose and don’t make the mistake of thinking you’ll be protected in a crisis.

    The whole point of hybrids is to put investors’ money at risk to protect the depositors and senior lenders who hold the real debt instruments.

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