Hybrid rush hits the market

PORTFOLIO POINT: ANZ and Westpac's hybrid issues have been well received by investors, and there's much to like in a lesser-known Australian dollar hybrid from Swiss Re.

ANZ Sub-debt versus the Westpac hybrid

The spate of hybrid issues continues apace, with ANZ and Westpac both accommodating market demand for the equity-debt security.

The Westpac mandatory converting hybrid WBCPC is the most recent entrant to the market, closing on Friday with some big names taking up space on the register. Co-founder of Harvey Norman, Ian Norman, bought $7 million worth of the hybrids via his holding company, Dimbulu, while a $6 million stake – or 0.5% of the total issue – went to Linda Van Lieshout, wife of the founder of furniture chain Super A-Mart.

The 11.9 million Westpac securities, each with a face value of $100, began trading at midday today (March 26) on a deferred settlement basis, and the first (fully-franked) dividend payment date is September 30. After tax, the dividend rate is 5.39% (based on a BBSW of 4.45% plus a margin of 3.25%) and the dividend is expected to be around $2.8205 per security, for the period between now and September 30.

ANZ is the lower risk security of the two. This issue sits higher in the capital structure than other recent hybrid issues, so is lower risk and thus offers a lower return. Further, there are no mandatory conversion clauses, again making this security far superior in terms of its risk profile. The return offered of BBSW plus 275 basis points seems fair in this market. The bond (ANZHA) started trading last week and closed at par ($100) today.

In contrast, the Westpac hybrid closed its maiden session below par at $99.80. This security, ranked very low in the capital structure and with many more risks than the ANZ subordinated debt, offered a yield of BBSW plus 325 basis points on first issue; the lower trading price means this yield would have increased slightly to 330 basis points. In my opinion, the return is insufficient to compensate for the risks involved.

Both issues were very popular, with ANZ having to lift its offer from $500 million to $1.5 billion, while Westpac increased its issue from $1 billion to $1.2 billion.

Swiss Re A$ FRN hybrid paying 11%

In my last article Bank Hybrids: not the only game in town, I highlighted an Australian dollar hybrid issued by an international insurer, Swiss Re, as being one of my favourites. I thought this week I’d explain why I like this hybrid, and give you a bit of background regarding Swiss Re.

Swiss Re is an international reinsurance company, ranked second worldwide after Munich Re. It is currently rated the same as our Big Four banks at AA-, yet while the banks’ hybrids are rated five notches lower than the issuer rating at BBB flat, the Swiss Re hybrid is rated A flat and offers close to 300 basis points in additional yield. So in a relative value context, we consider the Swiss Re Tier 1 hybrid as excellent relative value. Other reasons for our positive view of the security include:

· Swiss Re has always called its securities at the first opportunity. In June 2011, Swiss Re called its 3.75% CHF600m perpetual notes, despite reverting to a very cheap (1.52%) floating coupon rate – a positive sign that management intend to continue to call these securities at the first opportunity.

· This security has a step-up clause that increases the likelihood of call at the first opportunity. Under Basel III, bank securities with a step-up clause that aren’t called lose their contribution to regulatory capital. Insurance regulators have indicated they intend to follow bank regulation, so although not yet a regulatory requirement, it increases the chances of first call.

· Swiss Re has very strong credit metrics (see latest financial results summary below). We are confident in the underlying ability of the issuer to meet all interest and principal payments when due.

· Swiss Re issued a new USD Tier 1 security last week. The insurer planned to issue $300 million of this new security, but due to significant demand was able to raise $750 million, which highlights the company’s ability to access capital markets. This new security has been designed to comply with the tougher new regulatory environment. As such, it is of lower quality than the AUD Swiss Re Tier 1 security.

The new USD Tier 1 pays a fixed coupon of 8.25% to the September 1 2018 call date, which was roughly 6.60% over USD Swap at issue. However, the trading margin has already crunched in to 6.20%, which is slightly less than the AUD Tier 1, even though the AUD security is better quality.

The A$ hybrid (Tier 1 security)

· Perpetual Tier 1 step-up issued in May 2007 with a 10 year non-call period. First call on May 25 2017 and semi-annually thereafter on each interest payment date (at the option of Swiss Re only; the holder cannot require notes be called). As a perpetual note, there is no legal maturity date.

· Both fixed and floating lines. FRN at 6mthBBSW 117bp (payable semi-annually) and steps-up by 100bp to 217bp if not called. Fixed at 7.635% until 25 May 2017 then reverting to floating 6mthBBSW 217bp (payable semi-annually) if not called. Current yield to maturities are 11% for the FRN and 10.7% for the fixed.

· Issued by a special purpose vehicle ELM B.V. (a limited recourse special-purpose vehicle incorporated in the Netherlands). This structure is common to many insurance companies and banks (including many Australian major bank Tier 1s). In common with all three rating agencies, we view this structure as no additional risk.

· As Tier 1 securities, they are subject to potential optional and mandatory interest deferral – this was the focus of the market in 2008 and 2009. It is important to note that Australian insurers and even bank hybrids have many similar deferral rules in relation to their Tier 1 bonds/hybrids. The structure of the Swiss Re Tier 1 bonds is not dissimilar to local bank and insurance instruments.

About the company

Swiss Re is a Swiss-based global reinsurance company with a strong brand name and diversified business. It is the world’s second largest reinsurer after Munich Re.

The 2011 year was hit with the highest catastrophe-related economic losses in history, causing approximately $US116 billion worth of losses in the global insurance industry. However, despite these difficult conditions, credit rating agency S&P upgraded the Swiss Re issuer rating by one notch, from A to AA-, confirming excellent capitalisation levels (total equity grew from $US20.4 billion in FY08 to $US29.6 billion in FY11) and strong market position.

Swiss Re is a leading and highly diversified global reinsurer. The company operates through offices in more than 20 countries. Founded in Zurich, Switzerland, in 1863, Swiss Re offers financial services products to corporate, government and private customers through a network of 33 offices worldwide and employs over 2,700 people.

The company’s business segments in 2011 included:
Property & Casualty (P&C) – provides customers with sound risk transfer solutions for property, casualty and specialty lines, including credit and non-traditional businesses.
Life & Health (L&H) – offers clients tailored solutions to meet their risk and capital management needs.
Asset Management – manages assets that Swiss Re generates through other activities, ensuring that insurance and reinsurance liabilities match. In FY11, the division had $US150.6 billion of assets under management.

Latest trading results (to 31 December 2011)

Highlights of the result were as follows:
· Full-year profit was $US2.6 billion, up from $US863 million in FY10
· 4Q11 result was particularly strong, with $US983 million in profit that was more than three times the consensus estimate of $US298 million
· Property & Casualty (P&C) division delivered a 10.8% increase to $US12.04 billion ($US10.87 billion in FY10) in premiums earned. At the same time, strong underwriting results were seriously undermined by natural disasters’ burden over the period, resulting in a 48.1% reduction in operating income and $US3.4 billion impact on combined ratio (up 7.7% to 101.6% in FY11)
· Life & Health (L&H) division had a 2.9% increase in operating revenues. Operating income was affected by one-off costs and adverse market conditions
· Stand-out performance from the investment portfolio (or Asset Management division) with $US5 billion contribution towards profit for the year. The division reported 5.1% return on investment, up 1.6% compared to FY10 (see graph below)

Swiss Re investment portfolio

· Total assets decreased to $US225.9 billion for 2011, compared to $US228.4 billion in FY10

· Total debt fell significantly from $US29.2 billion to $US20.7 billion. The true debt figure is considered to be financial debt (as opposed to operational debt, which is excluded by the rating agencies from financial leverage calculations), which totalled just $US6.9 billion at December 31 2011 and was more than covered by cash and cash equivalents of $US11.4 billion at the same date

· Shareholders’ equity was up a huge $US4.3 billion year-on-year, to $US29.6 billion, as a result of the solid profits for the year, plus significant unrealised gains on the investment portfolio, mainly from ultra-safe government bonds that have risen in price as yields have fallen

· Solvency 1 ratio of over 200% and the Swiss Solvency Test ratio at 210%, indicating that capital is more than double that of the minimum regulatory requirements

· Strong insurance renewals (i.e. demand and price of new reinsurance contracts), which bodes well for FY12 results and beyond

· Excess capital at the Standard & Poor’s AA rating band was over $US7 billion at December 31 2011, according to company management

· Swiss Re have total investment assets of $US162 billion and total assets of $US226 billion, but only $US59 million is exposed to government bonds of the PIIGS

· Return on equity was up strongly, from 3.6% FY10 to 9.6% FY11

Swiss Re Tier 1 securities are over-the-counter and only available to wholesale clients in minimum face value parcels of $100,000.

Note: FIIG Securities provides detailed research to its clients on Swiss Re. All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.

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