Hybrids: Why take bond returns for equity risks?

PORTFOLIO POINT: Hybrid issues, like those made by ANZ and Origin Energy last year, contain some high-risk features for retail investors.

Through February and March this year, approximately $5.0 billion of hybrid or subordinated debt securities were offered to retail investors. The offers were made by Tabcorp, ANZ, Westpac, Colonial Finance, AGL Energy and Insurance Australia Group.

The offers were apparently well-received by retail investors, but institutional investors were more cautious, being well aware of the equity-like risks on offer with only debt-like returns.

With the exception of the ANZ Subordinated Notes, the form of the other security offerings mirrored that of two issues that were made in the second half of 2011 – ANZ’s CPS3 hybrid, completed in September, and the Origin Energy Notes (OEN) issued in December.

Both the CPS3 and OEN contained unattractive high-risk features for retail investors that were seemingly not appreciated or ignored, given the success of both issues. The unattractive features are those that allow 'equity credit’ to be given to the issues by APRA, in the case of CPS3, and the credit rating agencies in the case of OEN.

Interestingly, equity credit was marketed as a positive feature of the OEN, as it was for the Woolworths Notes II issued a month earlier, but the OEN achieved a 100% equity credit, while the Woolworths Notes II achieved only 50% equity credit. The reality is that equity credit means the securities are much closer to equity in the issuer’s capital structure – and in their features – than debt, and this should ring warning bells for retail investors.

Equity credit means that regulators and rating agencies will count at least a portion of the debt – if not all of it – as equity when calculating the issuer’s debt service ratios.

The CPS3 achieved equity credit from APRA because of the inclusion of a common equity capital conversion trigger in the terms and conditions, among other things. If this trigger comes into effect through ANZ’s common equity ratio falling below 5.125%, the CPS3 will convert into ANZ ordinary shares. What’s more, the maximum number of ordinary shares that CPS3 holders will receive will be determined from the face value of the CPS3 (A$100) divided by 50% of the ANZ share price at the time of issuing the CPS3 securities.

So if the share price was, say, $20 at the time of the CPS3 being issued, but the share price has declined in the meantime (i.e. below $10), a capital loss will be incurred by CPS3 holders. If mandatory conversion occurs, ANZ’s share price will be certain to have fallen – it will just be a matter of how far.

The common equity capital conversion trigger is a new APRA-imposed requirement for subordinated debt issued by Australian banks. Under its Basel III reforms, APRA expects all Tier 1 capital issued by the banks to be capable of absorbing losses.

The OEN achieved equity credit from the rating agencies because, among other things, of three critical structural aspects: mandatory coupon deferral upon loss of an investment-grade credit rating from Standard & Poor’s or Moody’s Investors Service; the very deep subordination; and a lack of incentives to redeem the notes at the five-year call date, combined with a sixty year term to maturity.

ASIC subsequently forced the removal of the investment-grade rating trigger and replaced it with Origin’s interest cover ratio falling below 3.5 times at any testing date, or Origin’s leverage ratio exceeding four times at any two consecutive testing dates.

The OEN are the lowest ranking of Origin’s obligations. Origin has $150 million of New Zealand preference shares that rank ahead of the OEN, and then all of its senior debt, bank loans and unsecured creditors rank ahead of the preference shares.

The OEN can be called by Origin in December 2016, but there is little incentive for them to do so. There is no coupon step-up until December 2036 – 25 years after issue – and while the equity credit from Standard & Poor’s lapses after five years, Moody’s will allow equity credit until December 2061 – 50 years after issue!

There is a not insignificant risk that the OEN will become perpetual (any bond with a term to maturity of more than 50 years is effectively perpetual).

The willingness of retail investors to overlook the significant risks that 'equity credit’ entails for them is attributed to the goodwill an issuer attracts. The issuers of these hybrid securities are Australia’s largest companies and are generally household names.

Retail investors tend to assume that nothing will go wrong and a seemingly generous coupon attached to the hybrid security helps allay any concerns.

But the reality is that retail investors are taking equity-like risks for bond-like returns. And, as with any bond, the risk profile is all to the downside; there is no upside, as there is with equity.

The best an investor can expect is to get their coupons paid on time and their principal back at maturity. Other than that, it is all downside risk – just ask the investors that bought hybrid securities issued by Elders and Paperlinx.

The Elders hybrid (ELDPA) was issued in April 2006, with a $100 face value and paying a deferrable coupon of 470bps over the bank bill rate. This was an exceptional credit spread in 2006.

Elders stopped paying the coupons after June 2009; the hybrid is perpetual and is currently priced on the ASX at $40.00.

The Paperlinx hybrid (PXUPA) was issued with a face value of $100 in March 2007, offering a deferrable coupon of 240bps over bank bills. It also has a 225bps coupon step-up, payable if the hybrids are not remarketed (effectively repurchased from investors) by June 2012.

Coupon payments were suspended in October 2011 and remarketing seems most unlikely, with the hybrids now priced at $15.00 on the ASX. The hybrid securities are perpetual.