Measuring up the better return: ANZ notes or equity?

ANZ announced a minimum $750 million capital note issue, last week. The announcement came in the week that Westpac had been expected to announce a similarly-sized subordinated note issue.

Westpac’s subordinated note launch is now expected this week but is going to have to run the gauntlet thrown down by ANZ. The expected pricing of the two issues is quite different but then so is the risk profile of the instruments involved.

Retail investors may struggle to reconcile the risk and return on offer and simply opt for the instrument offering the largest coupon – ANZ. But if this is the decision-making criteria, retail investors should buy the ordinary shares of either or both, instead.

With the recent sell-off in the local share market, both banks are offering grossed up dividend yields ranging from 8% to 10% (at the time of writing). The capital notes offer virtually all the downside risk of shares but none of the upside.

The structure of the ANZ capital notes follows the now familiar model established for Basel III compliant additional Tier 1 capital, that has been in place since Bendigo and Adelaide Bank launched its convertible preference share offer in September last year. Coupon payments are non-cumulative and solely at the discretion of ANZ and APRA, and conversion or write-off of the capital notes will take place upon the occurrence of a common equity capital trigger or non-viability trigger event.

APRA’s discretion in regard to coupon payments may be more critical than ANZ’s. While ANZ discloses that its common equity capital ratio sat at 8.2% at the end of March, Basel III requires the ratio be at 7% or more from the start 2016.

Should this requirement appear likely to be breached, APRA can be expected to exercise its discretion. Dividend payments will also be stopped at this point but can resume again when coupon payments restart. 

A common equity capital trigger event will occur if ANZ’s common equity ratio falls below 5.125% and a non-viability trigger event will occur if APRA decides the ANZ is on the verge of non-viability.

Upon either event the capital notes will convert into ANZ ordinary shares at a maximum ratio of one-fifth of the price of the ordinary shares at the time the capital notes were issued. If the share price has fallen below one-fifth of its original value then note holders will suffer a capital loss.

However, if conversion into ordinary shares is not possible at this time, then note holders will suffer a 100% capital loss as the notes will be written-off.

Interestingly, holders of ANZ CPS3 hybrid notes will not suffer the same fate. While the CPS3 are subject to the same common equity capital trigger, they are not subject to the non-viability trigger and the CPS3 cannot be written-off if equity conversion is not possible.

The CPS3 will remain in place as a debt obligation of the bank. This may not mean much in the unlikely event of the ANZ being wound up, but if it is deemed too big to fail and bailed-out with taxpayer funds, the CPS3 holders will be unambiguously better-off.

If nothing untoward happens, the ANZ has the option of redeeming the capital notes after eight years. Mandatory conversion into ANZ ordinary shares will occur after ten years, if the redemption option is not exercised.

However, mandatory conversion will only occur if the usual conversion tests are passed. In other words, so long as the ANZ’s share price has not fallen by more than 50% since the capital notes were issued. If the share price has fallen by more than 50%, the capital notes are perpetual, at least until the next coupon payment date, when the conversion tests will be applied again. 

Capital note investors are being offered a floating rate, fully-franked coupon of 320bps to 340bps over the 180-day bank bill rate. The margin to be paid will be set in a book-build scheduled to occur tomorrow and the offer will open on Wednesday.

Given that credit spreads on bank credit risk have widened recently, the coupon being offered by the ANZ doesn’t look very attractive. Westpac offered the same coupon on its capital notes when spreads on bank credit default swaps were priced around 100bps. Spreads on bank credit default swaps are now around 120bps (at the time of writing).

Moreover, redemption of the Westpac capital notes can occur after six years, not eight.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.