Caution note on Westpac’s newest hybrid

Westpac Capital Notes II (WBCPE) were lapped up by investors, but they don’t stack up on yield.

Summary: When Westpac issued its newest tranche of hybrid securities in May, investors raced to take them up. The WBC Capital Notes II were heavily oversubscribed by yield-seeking investors, with the issue amount increasing from $750 million to $1.3 billion. But the big question for income investors is: are they worth the risk?
Key take-out: WBC Capital Notes II (ASX code: WBCPE) were issued paying a coupon of 5.76% per annum. The current yield to maturity (YTM) is 5.66% and the annual grossed-up running yield (coupon divided by current price) is 5.55%. The dividend yield on Westpac’s ordinary shares grossed up is 7.43% – so from a pure yield play the shares look better value.
Key beneficiaries: General investors. Category: Fixed Interest.

Recommendation: Sell. Risk: Medium.

Westpac’s latest issue of hybrid securities, otherwise known as WBC Capital Notes II, were in hot demand when issued in March, and their price has gone up since listing in June, even though they yield less than Westpac (WBC) shares and are almost as risky.

Why would these hybrid securities prove so popular? Because, they are floating-rate notes. As interest rates rise over the next few years, so will the “dividend” from these hybrids. The bank’s shares, on the other hand, could see a cut in the dividend – unlikely, but possible.

In today’s article we assess WBC Capital Notes II from a value and yield point of view, and conclude that they are currently overpriced. But they may be worth holding as a hedge against rising interest rates, which could affect the value and the yield of Westpac shares.

Hybrid securities (also known as preference shares) have been sought after by investors due to their higher relative yield compared to other investments considered lower risk, such as bonds and term deposits.

Self-managed super funds (SMSF) have been major investors in securities such as hybrids because of the stream of income, which is relatively safe and certain. In recent times there has been minimal participation by institutional investors in hybrid issues, with more than 40% of hybrids owned by smaller investors with holdings of $50,000 or less (according to data from the ASX and Elstree Investment Management Limited).

WBC Capital Notes II (ASX code: WBCPE), one of the most recently issued hybrids, was issued paying a coupon of 5.76% per annum. The current yield to maturity (YTM) is 5.66% and the annual grossed-up running yield (coupon divided by current price) is 5.55%.

An investor buying WBCPE, especially with the view of holding to maturity (or “optional early exchange date”, which is the first date the issuer, Westpac, can convert to shares or pay back the face value), has to question whether it makes more sense to own the capital notes or the shares now. WBC’s ordinary shares dividend yield grossed up is 7.43% – so from a pure yield play the shares look better value.

The risks (albeit small) of holding the notes to maturity exist in the form of maybe not meeting the conversion test at maturity and the notes becoming perpetual – or in the case of an adverse financial impact on the bank resulting in the forced conversion to shares at probably the worst possible time to be holding the shares. Holding the notes in that situation would also not be the best scenario.

In the case of the ordinary shares there is the risk that the share price can fall and the dividend can be cut, especially as WBC may not continue to be as profitable in a rising rate environment.

Although hybrids are considered lower risk than ordinary shares due to being higher up in the capital structure, they are still risky. During the global financial crisis (GFC) hybrid prices collapsed alongside share prices, although the price falls of hybrids were lower especially when income was included in the return. Over the longer term hybrids have been almost half as volatile as shares.

Growing concerns about asset bubbles on the back of the search for yield are becoming a common theme. Whether or not bubbles are starting emerge in markets is unclear, but there is still a case for knowing the risk when paying up for yield.

The WBCPE hybrid issue

Earlier this year Westpac issued WBCPE, seen as a natural follow-on by investors in Westpac Stapled Preferred Security II (ASX Code: WBCPB), which are due to expire this year.

The initial offer of WBCPE was made to ordinary shareholders of Westpac shares and holders of WBCPB. The offer was enthusiastically oversubscribed by yield-seeking investors, with the issue amount increasing from $750 million to $1.3 billion.

The terms of the new notes are very similar to Westpac Capital Notes (ASX Code: WBCPD), and ANZ Capital Notes II (ASX Code: ANZPE). They are considered the “new-style hybrids”, issued with Capital Trigger Event and Non-Viability Trigger Event clauses, which force ordinary share conversion in the event of predefined financial hardship suffered by the bank (see table 1 for comparison of notes with similar terms).

Table 1 Comparison of Westpac Capital Notes II, Westpac Capital Notes and ANZ Capital Notes II
SecuritiesWestpac Capital Notes II (WBCPE)Westpac Capital Notes (WBCPD)ANZ Capital Notes II (ANZPE)
Current price ($)103.85104.2105.3
Official rankingPerpetual notePerpetual notePerpetual note
Risk characteristicsEquity-likeEquity-likeEquity-like
Distribution rate3mth BBSW rate 305bps3mth BBSW rate 320bps6mth BBSW rate 325bps
Distribution typeCash franking creditsCash franking creditsCash franking credits
Compulsory distributionsNoNoNo
CumulativeNoNoNo
Dividend stopper?YesYesYes
Principal repaymentWBC shares or cashWBC shares or cashANZ shares or cash
Mandatory conversion date123-Sep-248-Mar-2124-Mar-24
Optional early exchange date223-Sep-228-Mar-1924-Mar-22
Capital trigger Event3Tier 1 capital < 5.125%Tier 1 capital < 5.125%Tier 1 capital < 5.125%
Non-viability trigger event3YesYesYes
Issue date VWAP434.4829.8932.3
Mandatory conversion price517.2414.9516.15
Issuer ordinary share price as at today34.1634.1633.75
Ordinary share price exceeds issue date VWAP by?6-1%14%4%
Yield to Maturity on current price5.66%5.32%5.63%
Note.  As at 1 August 2014
1. Date on which mandatory conversion to ordinary shares is expected to take place.  
2.  Date on which issuer has the right to elect to redeem, arrange sale or convert early.
3.  Both Capital Trigger Event and Non-viability Trigger Event cause an immediate conversion into ordinary shares.
4.  Issue date VWAP is roughly the ordinary share price when the hybrids were issued and is used to calculate the Maximum Conversion Number.
5.  Mandatory conversion  WBC
6.  The more the current share price exceeds issue date VWAP, the less risk that the hybrid won't convert or the Maximum Conversion Number will cause a capital loss on conversion (all other things being equal).

WBCPE: Time to reassess

The additional risk with the latest hybrid securities, compared to previous issues, is of conversion not taking place on the mandatory conversion date.

For WBCPE, this means that there is a slightly higher chance of the share price falling to 50% of the issue VWAP price, which is around $17, where the “Conversion Conditions” are not met – and the notes become perpetual. Although a 50% fall seems unlikely now, if there was a GFC-like scenario in eight years’ time, the share price could fall to those levels. In comparison the WBC ordinary share price would have to fall to below $15 for the earlier issues of capital notes, WBCPD – maybe a less likely scenario.


Theoretical valuation

The investor is buying a floating-rate stream of income that is based on a fixed margin over the 90-day bank bill swap rate, plus the return of capital via conversion to ordinary shares at the maturity (mandatory conversion date or earlier if the issuer uses the “optional early exchange date”).

The value of the security using net present value can be subjective. The discount rate used is really arbitrary as is dependent on whether hybrids are considered bonds or equity, which determines the premium over the risk free rate of return. Hybrids offer a bonds-like return but can trade like equity during downturns, so they sit somewhere in between exhibiting characteristics of bonds and equity. I have used a discount rate of 8%, that sits between bonds and equity desired rate of return, to value the notes.

Based on the valuation in table two, WBCPE is currently trading on a premium of over 19% to what is considered fair value.

Table 2 Value of WBCPE
YearInterest paymentPremium paidValue now
15.681-0.484.82
25.797-0.484.56
35.951-0.484.34
46.168-0.484.18
56.348-0.483.99
66.448-0.483.76
76.593-0.483.57
8107.705-0.4857.93
Theoretical Value$87.15
Current price premium/discount to value19.17%

Note. Income forecast for the calculation uses the interest rate swap curve

Important factors to consider

The theoretical valuation may be useful as a guideline to the value of a security. But the YTM and how it compares to other securities, alongside factors such as the likelihood of the return of capital (or share conversion) at maturity, credit rating of the issuer, the trading margin and the spread of comparable corporate bonds should also be considered as follows:

  1. YTM: WBCPE is trading on an YTM that is approximately 1.8% lower than the grossed-up dividend yield for ordinary shares of WBC.
  2. Share conversion or perpetual: For WBCPE there is a slightly higher risk when compared to earlier issues of preference shares due to the longer term to maturity and the higher price of the ordinary shares at the time of the WBCPE issue, which impact whether conversion will take place.
  3. Credit rating: Moody’s has rated hybrid issues by WBC as Baa1 and the underlying issuer, Westpac, AA-.
  4. Trading margin: The trading margin is the difference between the YTM and the BBSW rate for the same maturity and is the return premium investors require relative to investing in banks bills (due to the higher risk of the securities relative to bank bills). The current trading margin for WBCPE has fallen and is comparable with the average spread on corporate bonds of similar maturity. The demand for the notes has caused the contraction in margins.

Recommendation

The valuation of the note shows it is trading on a large premium to what it is really worth. There is also the elevated risk with respect to conversion and the tighter trading margins. The notes are being priced in the market similar to floating-rate corporate bonds. Although hybrids may pay a constant income stream that is similar to bonds, the volatility of hybrids is about double that of bonds – so there is greater downside risk to be factored in for hybrids.

So the safety of the note is less certain going forward. Hybrids sit just above shares, with respect to the risk of capital – but are being priced closer to bonds.

For a yield play, the ordinary share of WBC on a yield of 7.43% grossed up is a better option as the yield is about 1.8% above that of the notes and the risks maybe similar.

Conclusion

Hybrids sit between bonds and shares. I believe hybrids can offer some downside risk protection relative to ordinary shares as although hybrids have been sold off sharply during major downturns, (the GFC) volatility is generally lower than ordinary shares.

The floating-rate component of the notes provides some protection when interest rates start to rise – but the difficulties of predicting interest rates movements with respect to timing and size can result in a different outcome for the return from the notes than expected.

The higher risk of “new-style” hybrids are a concern but the new conditions for meeting Tier 1 capital are more likely to strengthen the bank’s position, and the likelihood of owing the shares in the worst case scenario would probably mean that all financial assets are being sold down and it is difficult to escape the downturn (unless invested in cash).

The concern I have, with respect to WBCPE and other securities that have been bid up on the basis of yield, is buying assets that do not offer enough compensation in the form of return and may expose the investor to more downside risk than intended.

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