Higher-risk hybrids on the rise

Hybrid securities are evolving … and investors are being asked to accept more risk.

Summary: In the next year, more than $4 billion of ASX-listed hybrids will reach first call or maturity. Investors have the choice of rolling into new hybrid issues, but keep in mind that their structures have evolved and their terms and returns are now likely to be less favourable and higher risk.
Key take-out: Banks continue to dominate the hybrids issuance landscape, but a new trend in both the ASX and over the counter markets is the issuance of high-yield senior bonds with more defined terms and conditions from smaller companies offering yields as high as 9%.
Key beneficiaries: General investors. Category: Fixed interest.

Hybrids are a constantly evolving security class, changing to meet the needs of issuers and to provide income-based securities for investors seeking yield to fund retirement. The most recent changes in hybrid structures have been driven by tighter regulatory requirements post the GFC, which are increasingly in favour of the issuers while investors are asked to accept greater and greater risks.

Current trends include:

  1. High demand from retail investors.
  2. Expected maturity/conversion dates are lengthening.
  3. Returns are contracting.
  4. Few corporations are coming to the market, with banks still the main issuers – watch your overall allocations.

Domestic trends

Banks have been the dominant issuers of hybrids in recent times, and this looks set to continue for the coming 12 months.

In the next year, ASX-listed hybrids totalling $4.18 billion will reach first call or maturity. This includes $908 million of Westpac’s SPS II (WBCPB), which the new Westpac Capital Notes 2 announced last week is intended to replace. The SPS II have an early redemption date of September 30, 2014.

The new Westpac Capital Notes 2 are fully Basel III compliant and include the standard common equity capital trigger and non-viability determination clauses that would see the hybrids convert into Westpac shares should the bank come under duress.

The common equity capital clause has a 5.125% trigger, standard amongst other bank issues. Should capital fall below the trigger, the hybrids then convert to shares to top up capital and theoretically repair the breach. 

Older-style hybrids did not have these clauses and over time lose their contribution to capital. This loss of status means it is in the bank’s interest to replace the securities with “new-style” Basel III hybrids. However, contrary to the natural progression to new-style hybrids, the new hybrids can be replacing hybrids issued at very cheap rates and some banks may opt to keep them on issue as a cheap source of funding.

The new Westpac hybrids highlight the continuing trend of longer terms until first call/conversion/redemption and many options for possible repayment (which investors must evaluate) including:

  1. Option for Westpac to convert, redeem or transfer the notes on September 23, 2022 (over eight years).
  2. Scheduled conversion date September 23, 2024 (over 10 years).
  3. If neither point one or two above occur, the notes become perpetual (no maturity date).
  4. Will convert to shares on breach of a capital trigger of 5.125%.
  5. Will convert to shares at APRA’s determination of “non-viability”.

Conversion in the last two instances would occur at a time of distress for the bank and I would expect the share price to be falling rapidly, and investors would likely face a loss. The other possibility is that neither of the two call dates is met and the hybrids become perpetual. In other words, the bank never has to repay investors. In that instance you would have to sell to recoup capital at the going market rate, again with the possibility of a loss.

The other apparent trend is the decline in rate of return; in part attributed to contracting credit spreads as the retail market demands lower-risk premiums and in part due to high demand from investors seeking higher income to compensate for low deposit rates.

Banks now include franking credits in the margin over the bank bill swap rate. The new Westpac 2 Notes were priced this way (BBSW plus 3.05%), with an estimated yield of 5.73% per annum until the next rollover date, adjusted for franking, resulting in a cash return of just 4.01% or $4.01, with the remainder of 1.72% being franking credits that, if investors can claim them, requires them to wait for the Tax Office to pay.

The banks have access to multiple markets including: ASX listed, domestic over-the-counter (OTC) and various foreign currency OTC markets. Just like an investor wanting to borrow to buy a house, they search for the cheapest market to issue the hybrids. That market continues to be the ASX-listed market, which predominantly serves retail investors. Banks have not issued any “new-style” hybrids in the OTC market.

It has been quite some time since a corporation has issued a hybrid in either the ASX or OTC market. There are a couple of reasons for this, the main one being loss of “equity credit status” from the credit rating agencies. In essence, companies were able to issue hybrids and the capital raised was not counted as debt, so it was excluded from debt ratios, enabling companies to maintain existing credit ratings. The loss of 100% equity credit status has made hybrids a less attractive avenue to raise funds.

Cheap bank funding or cheap foreign currency OTC bond markets have been used instead.

A new trend in both the ASX and OTC markets is the issuance of high-yield senior bonds with more defined terms and conditions from smaller companies. Unlike the hybrids with a myriad complex scenarios, these new bonds are straightforward and structurally easier to understand. Current yields on offer are as high as 9% per annum.

International trends

Issuance of bank hybrids in international markets has grown to meet new Basel III regulations. Two interesting developments include:

  1. A range of capital triggers. UK banks Barclays and Lloyds, as well as others, have issued hybrids with 7% capital triggers, meaning they convert to shares at a higher level and are greater risk. Yields on offer are higher and they have been attractive to yield-seeking investors.
  2. The inclusion of write-down and write-back clauses, where hybrids take a loss in capital value that can be restored at a later date if the capital position of the bank recovers.

Conclusion

Hybrids are complex investments, and terms and conditions can vary even from the same issuer. Older Basel III compliant bank hybrids may offer better terms and conditions for similar returns compared to the new issues.


Elizabeth Moran is director of education and fixed income research at FIIG Securities.

* She will be appearing at Eureka Report’s ‘Maximising Income for the Future’ conference to be held at Sydney Town Hall on Tuesday May 27: To find out more about the event or book a ticket please click here.

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