Challenger's hybrid issue stacks up

Just when you thought you could take a breather, another hybrid issue has been announced. This time, however, it’s not a big four bank but Challenger Limited (CGF) and the terms of the capital notes issue look more encouraging – especially when compared to the recent CBA PERLS VII issue – as they offer better value.

The notes are likely to be issued on a gross yield of 6.04% and gross yield to maturity (YTM) of around 6.32% – while the current gross dividend yield of Challenger’s ordinary shares is only 3.58%.

Yield to maturity is the expected return based on the current price, assuming all distributions are made through to conversion, and the face value of the security is realised at maturity.

Pricing is attractive

The $250 million issue of capital notes by Challenger is smaller than the $2.6 billion PERLS VII issue and is at a higher margin above the bank bill swap rate (BBSW), even if the pricing is at the lower end of the expected range of 340-360 basis points (bps) (compared to 280 bps for PERLS VII).

The same risks exist for investors as other hybrid issues, with the reason for companies issuing these types of securities being to shore up the capital base to absorb the impact of any future adverse events.

Investors must remember that hybrid notes are not fixed interest; they won’t protect portfolios from equity downside risk to the same extent as bonds. But the issue by Challenger is attractive based on the gross yield (relative to Challenger shares) and is better priced (relative to other recent hybrid issues with respect to gross yield).

While I had misgivings (see Why CBA’s PERLS VII isn’t a pearler), the recent issue of CBA PERLS VII was well received by investors. More hybrid issues may be issued by the banks in the future – especially in the event that the Australian Prudential Authority (APRA) increases the expected minimum capital levels.

Challenger Limited is the major provider of annuities in the Australian market under its subsidiary, Challenger Life Company (CLC), and is issuing the notes to boost additional tier one capital. The company’s extra capital will support their target of achieving of 12-14% growth in retail annuity sales in the next financial year amid the anticipated boom in annuity sales as the population ages.

The terms of Challenger’s hybrid security are similar to the recent issues by Westpac (see Caution note on Westpac's newest Hybrid) and CBA with capital triggers and non-viability clauses, which can force conversion to shares if Challenger suffers financial hardship.

Yields of other hybrids don’t meet the risks

The current gross yield of the recent bank hybrid issue by CBA is not indicative of the risks attached to the securities. On top of that, prices have moved up on the back of the demand for yield, leading to compression of the yields of other listed hybrids.

Investors have participated in the banks’ hybrid issues based on the idea that the big four banks cannot fail. The banks have mostly put in solid performances supporting this view, with some good financial results recently, as well as providing investors with excellent gross dividend yields and share market returns.

But the risks are in the longer term rather than current. The financial stability of the banks in the event of another GFC-like scenario have been brought into question recently, with David Murray’s Financial Systems Inquiry asking whether the tier one capital levels are sufficient. Indeed, during the GFC some of the banks did come close to what would now trigger the conversion of the hybrids into shares as their capital levels fell near the minimum range to what APRA sees as adequate.

The pricing of Challenger's capital note is based on two key factors:

1. It is not a big four bank so does not have the fire power to gain investor support, and;
2. The capital levels of the company are in a better shape relative to the banks which may mean a lower likelihood of further similar capital raisings.

While the distribution isn’t fully franked and will be at around 70% franked, the level of franking is higher than the dividend of the ordinary shares (at around 23%). Further, franking levels can change with the fortunes of the company.

The notes’ gross yield is compelling

The partially franked dividend yield of 3.58% of the ordinary shares does not make Challenger a yield play, compared to other higher yielding companies that are bought on that premise. However, this has not prevented the share price of the company doing quite well this year.

A gross yield of at least 6.04% per annum payable by the notes (actual yield of 4.64% per annum for the first distribution) is likely to be viewed as attractive for investors looking for a solid regular annual payment (see table 1).

But remember the risks

Some of the key risks to consider are:

• The price may fall below the face value of $100 depending on demand in the secondary market (listed market);
• Liquidity, as the issue size is small;
• Distributions are discretionary and non-cumulative;
• The distribution rate may become less attractive compared with rates of return on comparable securities if interest rates rise, and;
• Distributions may not be franked depending on Challenger’s available franking credits – which can be impacted by business performance, changes in the corporate tax rate, and amount of other distributions payable by Challenger that are franked.

A shorter time frame with a reasonable return

Despite some of the usual concerns associated with hybrid securities, the payment of a gross yield at least 2.46% above the ordinary shares’ gross dividend yield will provide a reasonable return, pricing in the risk relative to other securities higher in the capital structure.

The shorter time of six years to the likely first call date – when cash may be returned or the notes exchanged for shares – also increases the appeal. The shorter the time to getting your money back, the less likely the occurrence of adverse events that could impact the company’s capital base and cause the share price to fall to levels where the notes cannot be exchanged for shares or cash. 

The issue opens to shareholders and the public on September 4, 2014 until September 30, 2014, and an application form can be found attached to the prospectus (which can be downloaded here.

*The information in the article was correct at the publishing date, but since then I have spoken to Challenger (9 September 2014) and was told that because the broker firm offer was over-subscribed, the general public offer was not implemented.