Before chasing bargains: know your hybrids

The recent sell-off of hybrid notes listed on the ASX has seen the market price of a number of notes fall below face value. Typically, these notes have a face value of $100 but a number are now trading around $98 or less.

Brokers specialising in this sector have become very excited and have been promoting the affected notes to retail investors on the basis that the price falls present an opportunity to gain a higher yield to call, than what was available only a month or so ago.

With the sale of the Commonwealth Bank's PERLS VII hybrids last month, the bookbuild for the issue set a record low margin for the calculation of dividend payments. The margin was set at just 2.80% over the 90 day bank bill rate.

Even now, almost four weeks after listing, the PERLS VII hybrid is trading at less than $97.40, offering investors a margin of 3.37%. This is not as good as the margin on the PERLS VI, which was set at 3.80%, but it is certainly better than the 1.00% reduction that was offered to the PERLS VII investors who bought into the issue.

Other recent issues trading below par value include the Challenger Capital Notes (CGFPA) at $98.50 giving a trading margin of 3.88%, the Macquarie Bank Capital Notes (MBLPA) at $96.45 with a margin of 4.23% and the Bendigo and Adelaide Bank CPS2 notes (BENPE) at $98.90 with a margin of 3.53%. The issue margin on each of these hybrid notes was 3.40%, 3.30% and 3.20%, respectively.

The poor market performance of each of these recent hybrid note issues can be attributed to more than $4 billion of hybrid note issues hitting the market in the same month. It can also be attributed to the issues listing on the ASX at the same time as the recent bout of volatility hit global financial markets.

Shares in each of these issuers were selling off just as their hybrids commenced trading. Not surprisingly, the hybrid prices moved in the same direction, if not to the same degree. 

Bargain-hunters beware

But before investors go looking for the “bargains” now on offer among listed hybrid notes, it is worth being aware that not all hybrids are the same. There are some important differences among hybrids that can significantly alter the return that may eventually be earned, depending on which hybrid note is purchased.

Bendigo and Adelaide Bank (BEN) provides a good example of the spectrum of different hybrid securities that are listed on the ASX. BEN also provides a more generous treatment for investors in its Additional Tier 1 capital should the capital be written off, than most other banks.

More on this later.

The Bendigo Floating Rate Capital Notes (ASX code: BENHB) are the least complex of the hybrid securities BEN has on issue. The FRCNs are perpetual preference shares on which coupons can be deferred, but if deferred, will accumulate. The BENHB notes can also be redeemed at any time, subject to APRA approval.

The notes have been progressively redeemed and now only $35 million of notes remain outstanding.

The Bendigo Preference Shares (BENPB) qualify as transitional Additional Tier 1 capital. They were issued before the Basel III rules on Additional Tier 1 capital came into effect.

As such, dividends are discretionary and non-cumulative but there are no provisions for mandatory conversion into ordinary equity or write-off. While there is provision for the BENPB notes to be perpetual, they are expected to be called by BEN in June 2015.

However, the Bendigo Converting Preference Shares (BENPD and BENPE) are fully Basel III compliant. Thus dividends are discretionary and non-cumulative, and the notes include capital and non-viability triggers that can cause the notes to be converted into ordinary equity or written off, if pulled.

Conversion or write-off of the notes will inevitably result in capital losses for note holders. While conversion may not result in a complete loss of capital, a write-off typically will.

However, BEN provides for note holders to be treated as shareholders in a subsequent winding-up of BEN, if the notes are written off beforehand. The note holders will be treated as if conversion had taken place.

Of course, this concession may be worth very little, as it is unlikely that shareholders would recover anything at all in a winding up of the bank.

Making comparisons

NAB also makes this concession for holders of its Additional Tier 1 capital. ANZ, CBA and Westpac do not.

There is also a range of different hybrid notes issued by Australian companies listed on the ASX. Each one of these comes with differing terms and conditions and any investor contemplating purchasing these notes should fully acquaint themselves with the prospectus for the issue first.

Understanding the differences between them is imperative. Some were issued with 60-year terms to maturity – you might not be around to get your money and neither might your kids – your grandkids are a possibility.

The bottom line for potential investors is this: know what you are buying. But as a general rule, the older the issue, the more investor-friendly the terms and conditions that apply.       

This is an edited version of a story that first appeared in Banking Day. www.bankingday.com.