Hybrid blitz

PORTFOLIO POINT: A rush of bank hybrids hits the market aimed at retail investors. But are they paying enough margin?

It never rains but it pours '¦ throughout most of last year retail investors in hybrids and interest bearing securities hungered for new issuance but it never seemed to materialise. However, in the past fortnight there has been a blitz of new issuance, particularly among the banking sector with retail-focused notes that can generally be acquired for a minimum allotment of $5000.

As the Australian bond market remains underdeveloped, it is always difficult to unearth independent coverage of these notes. There is only a handful of brokers dealing in fixed interest and invariably the brokers who “cover” the notes are also selling the same issues.

In the table below you can see the key details of the three recent bank hybrids: the ANZ subordinated note (ANZHA); the Colonial Subordinated note (Colonial is a subsidiary of CBA) (CNGHA); and the Westpac CPS (WBCPC).

However, the new range of hybrids has not pleased everybody, Philip Bayley, in the article below (reproduced with permission) points out a range of issues, including some key failings in the latest Westpac hybrid. – James Kirby, managing editor

-Comparison of new bank issued securities
	Westpac CPS	Colonial Sub Notes	ANZ Sub Notes
ASX code:	WBCPC	CNGHA	ANZHA
Security type:	Preference share	Subordinated Debt	Subordinated Debt
Distribution type:	Floating rate Dividends	Floating rate coupons	Floating rate coupons
Distribution frequency:	Semi-annually - subject to solvency tests	Quarterly - subject to solvency tests	Quarterly - subject to solvency tests
Margin range:	3.20% to 3.50% p.a. (to be determined by Bookbuild)	3.25% to 3.75% p.a. (to be determined by Bookbuild)	2.75% to 3.00% p.a. (to be determined by Bookbuild)
Distribution type:	Includes franking	Cash	Cash
Indicative gross distribution rate:	7.56% to 7.86%	7.61% to 8.11%	7.11% to 7.36%
Call features:	Callable at 6 years and each Dividend Payment Date thereafter	Callable at 5 years – Issuer incentivised to call at 5 years due to immediate loss of equity credit from ratings agency	Callable at 5.25 years – Issuer progressively loses regulatory benefit over subsequent 5 years
Maturity:	Perpetual but convertible into shares	25 years, if not called	10.25 years, if not called
Equity risk:	Conversion at 8 years @ 1.00% discount (subject to Conversion Conditions) as well as other specified circumstances	No	No
Capital trigger event:	Yes (but bank well positioned and probability very low)	No	No
Source: RBS Morgans

The market is crowded with hybrid bank issues, following Westpac’s launch of an issue of convertible preference shares. ANZ and Colonial launched subordinated note issues in recent days..

Westpac is seeking a minimum of $750 million. The preference shares should be priced at the higher end of the 320 to 350 basis points range for the margin applied to the bank bill rate to determine the dividend paid.

The margin will be determined in the institutional book-build scheduled for February 23.

The structure of the converting preference shares is very similar to ANZ’s CPS3 issue completed last September. The Westpac CPS features deferrable and non-cumulative dividends, and there is also the APRA-imposed common equity conversion trigger that could result in a capital loss to investors.

The Australian Prudential Regulation Authority now requires all Tier-1 capital raised by banks to be capable of absorbing losses. The Westpac CPS qualifies as non-innovative, residual Tier-1 capital.

The "compensation" for investors taking this risk is the additional margin that will be used to determine the dividend to be paid. ANZ’s CPS3 have a margin of 310 basis points.

However, credit spreads in bond markets have widened considerably since September and, it must be said, the margin being offered by Westpac does not reflect this, especially given the considerable risk involved.

The non-cumulative dividends will be franked if Westpac has sufficient franking credits or, if not, will be grossed-up to reflect the benefit of franking. But the dividends will only be paid if the directors determine, at their discretion, that a dividend is payable and that the amount to be paid does not exceed distributable profits, and it is approved by APRA.

If a dividend is not paid, then Westpac is prohibited from paying a dividend on its ordinary shares or buying back its ordinary shares. That this restriction applies only to Westpac’s ordinary shares, shows how lowly ranked the CPS are in the bank’s capital structure.

CPS are deeply subordinated securities

The perpetual CPS will be listed on the Australian Securities Exchange. If the CPS are not eventually converted into Westpac ordinary shares, transferred or redeemed, the ASX listing will allow investors to retrieve their capital.

However, if it comes to that, they can be assured of a capital loss – just look at the current value of the various income securities issued by the banks in the late 1990s.

Nevertheless, there are reasonable prospects for the CPS being converted into Westpac ordinary shares within a relatively short period of time. The scheduled conversion date is the end of March 2020 and there is also an early conversion date at the end of March 2018.

But conversion will only occur if the conversion conditions are met, and, in the case of the early conversion date, only if APRA approves. Investors are warned not to expect approval from APRA.

For the conversion conditions to be satisfied, Westpac’s share price must not have fallen to 56%, or less, of its value at the time of issuing the CPS, when it is 20 days away from the conversion date. In addition, Westpac’s share price must not have fallen to 50.5% or below on the conversion date.

These conditions must be met for conversion to take place. Hence the CPS are perpetual.

As for the mandatory common equity conversion trigger, this will come into effect should Westpac’s core Tier-1 equity ratio fall to 5.125% – the same as for ANZ’s CPS3. Investors will receive no more than the maximum number of ordinary shares they would have received under a scheduled or early conversion.

At such a point, investors can expect a capital loss, as the share price is likely to have fallen below 50.5% of what it was at the time the CPS were issued.

Philip Bayley writes for Banking Day newsletter, in which this article first appeared.