Hybrids and the Basel bump

Basel III imposes tighter capital requirements on some fixed income notes, but they remain attractive investments.

PORTFOLIO POINT: Some popular hybrid bank notes will no longer qualify as Tier 1 capital under new requirements, and the situation is confusing, but investors holding them should consider the potential upsides.

The fallout from the GFC continues to felt by financial institutions and banks. In particular there are evolving rules concerning both tighter banking regulation and the requirement for higher capital ratios. The rules surrounding the development of Basel III are particularly focused on lifting the capital ratios of banks.  

Overseas, the formation of a central regulatory body to govern future banking practices is being hotly debated in Europe. Its success possibly depends on where the regulatory power ultimately resides. Will it be Germany or France? Then the position of the UK needs to be considered for its banking market sits outside the euro zone and London hosts a bigger financial intermediation market.

This debate and regulatory framework is very relevant for Australian banks and places a spotlight on the status of two of the investment positions in our income portfolio - National Income Securities (NABHA) and Macquarie Income Securities (MBLHB).

These securities were both issued as Tier 1 capital securities and they are perpetual. Both were issued prior to the creation of Basel III. However, and importantly, neither security could be issued today and qualify as Tier 1 capital. Therefore, both are now subject to transitional arrangements whereby they will progressively move from Tier 1 capital to some other form of debt. These transitional arrangements are not clear and neither Macquarie Bank nor National Australia Bank has clarified the future status of these securities – so much for continuous disclosure in our market. From an owner’s perspective, this transition may be regarded as very positive or possibly merely as noteworthy. Time will tell but the large uptick in trading of MBLHB in recent weeks suggests that these securities need to be watched.

So let’s review the terms of both and speculate on what may happen in the future to these securities. Hopefully we can then decide as to whether they should remain in our portfolio.

Terms and Review

NABHA

MBLHB

Type

Tier 1 capital

Tier 1 capital

First Issued date

8-Jul-99

25-Nov-99

Term

perpetual, i.e., no legal maturity date

perpetual, i.e., no legal maturity date

Issued at face value

$200 million

$400 million

Face value

$100

$100

Margin

125bp over BBSW90

170bp over BBSW90

Payment frequency

quarterly

quarterly

ex-payment date

Jan, Apr, Jul , Oct

Mar, Jun, Sep, Dec

Payment date

Feb, May, Aug, Nov

Jan, Apr, Jul Oct

Last price (24/10/12)

$71.19

$65.00

Source: IRESS and company’s PDS

To determine the investment case for these securities we have reviewed several Australian Prudential Regulation Authority (APRA) rulings and information guides in relation to non-compliant Tier 1 capital. Unfortunately these documents are written in such a way that a degree in law may be required to understand the details.

The following is a summary of the stated position of APRA. Some directly relate to MBLHB and NABHA:

  1. Some financial hybrids (Tier 1 capital) issued by banks in the past will not be Basel III compliant. However, capital instruments issued before December 17, 2009, that complied with APRA’s prudential capital requirements in force at the time of issue may be eligible for the transitional arrangements provided by APRA – this relates to MBLHB and NABHA.
  2. All new Tier 1 hybrids issued post January 1, 2013, must be Basel III compliant and we are starting to see a few recent Tier 1 hybrids being issued which satisfy this regime, e.g. CBA’s PERLS VI (CBAPC) and Bendigo Bank’s recent issuance (BENPD). 
  3. All Basel III compliant hybrids must be able to absorb loss and the capital must be permanent.  In other words, all Tier 1 capital issues will be CPS (converting preference shares) with a mandatory conversion at a specific date or on an event.
  4. Going forward all Basel III compliant Tier 1 hybrids require conversion clauses or terms that include a Non-Viability event and a Capital event. For instance if the common equity ratio of the issuing bank falls below the specified ratio (capital event) as per APRA’s requirement ( 5.125% in the case of a capital event), Basel III compliant Tier 1 capital will be forced to convert to ordinary shares. 

Investors need to understand the new Tier 1 hybrids that are Basel III compliant are much riskier than the older style existing financial hybrids (NABHA and MBLHB). 

Transitional relief

Existing Tier 1 hybrids which are not Basel III compliant have been given transitional relief for a specific time frame. This is where MBLHB and NABHA reside. They have been given up to 10 years to transition and so will lose 10% of their weighting towards Tier 1 capital each year effective January 1, 2013.

If this sounds confusing and you need clarification then don’t feel alone. You may ask your advisor or broker for their view but ultimately it is the issuing companies that should clarify this position.

My thoughts on this are as follows. As a security drops out of Tier 1 (or 100% risk capital) then its ranking improves in the risk scale. This is good for the owner. With less risk and with less of the security supporting capital then the historic terms becomes unattractive for the issuer. In this case and over time both NAB and Macquarie may decide that the cost of servicing these issues is too high given that it is no longer Tier 1 capital. Should they come to this conclusion, they may well decide that these issues should be renegotiated or restructured – but that requires the security owner’s support. A revaluation of the security could occur in this circumstance or there may even be a case for a buy back. 

A consideration of a buyback is an interesting topic because Macquarie Group has recently undertaken a buyback of ordinary shares funded by a capital return from the Macquarie Bank subsidiary. This subsidiary is issuer of the MBLHB and it is unclear as to why the Bank chose to return capital rather than redeem these notes.

Both securities may look boring to investors but they do offer some corporate potential. Given this and the current yields offered on these securities then they remain in our portfolio. 


John Abernethy is the Chief Investment Officer at Clime Investment Management.

If you’re a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime are offering you the opportunity to discuss your portfolio and investment options with John Abernethy. Click here to register your details.

Clime Income Model Portfolio - At October 25
Hybrids/Pseudo Debt Securities
Company Market Price ($) Margin over BBSWRunning YieldFrankingTR (%)
ANZHA$103.602.75%5.72%0.00%4.49%
MXUPA$78.103.90%9.07%0.00%9.11%
AAZPB$93.654.80%8.52%0.00%7.33%
MBLHB$64.501.70%7.57%0.00%11.14%
NABHA$71.171.25%6.22%0.00%6.78%
SVWPA$86.554.75%9.12%100.00%9.65%
WOWHC$106.253.25%6.05%0.00%4.13%
RHCPA$101.954.85%7.84%100.00%5.23%
High Yielding Equities
Company Market Price ($) FY13 Dividend ($)GUDYFrankingTR (%)
TLS$4.07$0.289.83%100.00%16.52%
AAD$1.37$0.139.52%0.00%7.26%
CBA$57.30$3.488.68%100.00%13.58%
WBC$25.26$1.739.78%100.00%18.22%

Return since June 30, 2012: 9.55%

Returns since Inception (April 24, 2012): 8.42%

Average Yield: 8.16%

Start Value: $118,757.19

Current Value: $130,101.50

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