Hiding the hybrids facts

PORTFOLIO POINT: Even though retail investors can’t access the credit ratings on hybrid issues, the bigger problems for investments relate to the structures of some of these issues.

The $9 billion rush of subordinated and hybrid note issuance so far this year is attracting a slew of warnings on these products, not least from the corporate regulator ASIC.

Yet the note issues just keep coming ... earlier today CBA announced the latest $750m note in its highly successful PERLs series (see more at the bottom of this feature).

Risks abound for retail investors in hybrids, and it seems the average investor has less information readily available than the institutions when it comes to things like access to issue credit ratings and equity credit criteria.

Investors are being attracted to hybrid investment opportunities offered by household names with trusted brands and offering high yields. The subordinated notes and converting preference shares on offer are being pitched as ‘safe’ debt investments, yet they are complex instruments with significant risks attached.

ASIC advised investors to think hard about the investment opportunities being offered: to read and understand the prospectus and, if still unsure, to seek unbiased professional advice.

The regulator also noted that among the risks that attach to the various hybrid notes being offered is a 60-year term to maturity, along with the possibility that coupons won’t be paid, the market price of the notes may fall, and that the notes are subordinated in the capital structure of the issuer.

The watchdog did not mention names, but Goodman Group disappointed investors in its PLUS notes when it advised only a couple of weeks ago that it will not be redeeming the notes as expected in March next year. Instead, investors will receive new PLUS II notes with a December 31, 2073 maturity, to replace their old PLUS notes

Yes, you did read that correctly. It is not a typo – the PLUS II notes will mature at the end of 2073. I think it’s a fair bet that none of the current PLUS note investors will be around to collect.

Following the release of ASIC’s warning, calls were made for the credit ratings on these notes to be disclosed to retail investors. Institutional investors can be made aware of the credit ratings but retail investors can’t; this, it was said, puts retail investors at a disadvantage.

Since the beginning of 2010, rating agencies have been required to be licensed. The three main agencies, Fitch Ratings, Moody’s Investors Service and Standard & Poor’s hold wholesale licences but not retail licences.

As a result, the ratings assigned by these agencies can only be disclosed to wholesale investors and not the general public. The agencies do not hold retail licences because they refused to join the dispute resolution scheme offered by the Financial Ombudsman Service.

Only one rating agency holds both a wholesale and retail licence, and that is Australia Ratings.

Nevertheless, revealing the ratings assigned to these instruments would be of little benefit to retail investors. The rating will convey only two pieces of information: the probability of the issuer defaulting and an assessment of the recovery prospects in the event of a default.

The probability of default is reflected in the credit rating assigned to the issuer, as opposed to the instrument, and the level of subordination of the instrument will be reflected in the rating assigned to the instrument. Thus, if the issuer is rated ‘BBB’, the rating assigned to the hybrid note may be two notches lower, at ‘BB ’, to reflect the deep subordination of the note in the capital structure of the issuer.

The credit rating assigned to the hybrid note will not address the risks highlighted by ASIC. It will not address or discuss a 60-year term to maturity, the risk of coupons being suspended or the risk that the market value of the hybrid note may fall.

These hybrid instruments are being offered to investors solely because of the ‘equity credit’ that the major rating agencies will give to the issuers of the notes. To understand ‘equity credit’ and how this determines the terms and conditions attached to the notes and why, in all likelihood, the notes will not be redeemed when expected, it is necessary to undertake further research.

That further research involves going to websites of each of the major rating agencies and reading their criteria on the granting of ‘equity credit’. It is necessary to do this for each one, because each is different.

It is a lot of trouble, but, doing so will be rewarding. Reviewing Moody’s criteria for example, will explain why some of these instruments have a term to maturity of 60 years. Moody’s will only grant ‘equity credit’ if the term to maturity is at least this long.

But reviewing rating agency criteria is a job for professionals. This is why retail investors should seek unbiased professional advice before investing in hybrid notes.

And, ask your advisor if they have read the rating agency criteria on ‘equity credit’.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He is also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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CBA PERLS VI

Commonwealth Bank is aiming to raise a minimum of $750 million with a new series of convertible preference shares, the PERLS VI (CBAPC). Broker RBS Morgans says the margin, to be set on bookbuild between 3.8% and 4%, will be the highest ever margin on a major bank-issued preference share on the ASX. The securities will pay distributions four times a year, however these are discretionary, and there is a mandatory exchange into ordinary shares on December 15, 2020, unless redeemed on the December 15, 2018 call date. The money raised will be used to repurchase the maturing PERLS IV (CBAPB). The offer will be Tier 1 capital for regulatory requirements, with a minimum subscription of $5,000, and rank above shares, but below retail bonds, senior debt, deposits and covered bonds.

Silver Chef

Equipment rental group Silver Chef is aiming to raise between $20 million and $30 million with a senior unsecured bond. The offering will be managed by fixed-income specialists FIIG Securities, and this is the first issue being promoted by the new fixed income origination team at the broker. The Silver Chef bond plans to pay a coupon of 8.5%, twice a year, with a six-year maturity. It will have no prospectus or other disclosure documents, and no credit rating, and will not be listed on the ASX. The offer is only open to those who qualify as professional and sophisticated investors, with a minimum subscription of $50,000.