NAB notes that need redemption

National Income Securities

The calamity in Cyprus is regarded by many as an isolated and possibly insignificant financial event. I am not sure, for it does starkly show that banks are important and highly leveraged entities.

A nation’s banks need to be well regulated and expertly managed, for if they falter then they can push a government into default. We now know that the banks of Cyprus were too large for the Cypriot government or its central bank to support. This became an issue because the Cypriot central bank could not print euros, unlike its big central banks cousins across the world.

It is against this background that I thought I might review one of my bank security holdings.

Readers will note that National Income Securities (ASX code: NABHA) features in the model income portfolio. On their face these appear to be fairly innocuous “perpetual” securities that were issued by National Australia Bank (NAB) in 1999. In that year, and under the then generally adopted international capital rules, NABHA were accepted as Tier 1 capital and therefore bolstered NAB’s capital ratio.

The yield on these notes also appears to be a rather miserly 1.25% above 90-day bank bills. Therefore, with bill rates currently at just 3.1% these notes are yielding about $4.35 on their $100 face value. Of course, at current market prices of about $71 the annualised running yield is about 6.2%; further the interest rate is floating, reset and the interest is paid every 90 days.

Events since the time of issuance, and in particular the GFC, have led to a reassessment of what now constitutes Tier 1 capital. Now it has been deemed by international authorities and adopted by APRA that NABHA do not now qualify. However, rather than wiping them immediately from the highest tier capital, a transition period has been determined. Thus, over the next 10 years the NABHA will progressively lose their capital weighting. Ultimately these notes should be redeemed, but NAB retains this option at its sole discretion.

These notes, which I reiterate trade at a substantial discount to their $100 issue price, have an interesting term whose consequences may not be fully appreciated by the market. Indeed, they have a term which may become very important should there be a sharp economic downturn in Australia similar to that suffered in 1992. So let’s imagine a time when a sharp lift in unemployment causes a lift in nonperforming residential loans and the banks in general suffer from small business bad debts that tips them into losses and close to their minimum tier 1 capital requirement. Is this farfetched in this current era? Unfortunately not, and it is exactly what transpired in the US in 2008, across Europe in 2009-10, and in Cyprus right now.

Background

National Income Securities are actually stapled securities. They have a fully paid note and a nil paid preference share. Should an event of default occur, then the note is effectively converted to a fully paid preference share of $100 (see below). An event of default (effectively an insolvency event or a loss of the banking licence) does not trigger a redemption right but merely places the NABHA in a wind-up line ahead of ordinary shares and equally with the recently listed National Bank convertible preference shares (ASX code NABPA).

To quote from the 1999 prospectus:

“In certain limited circumstances (such as if an Event of Default occurs), the Preference Share which is a component of a National Income Security will become fully paid. In such circumstances you would not have to pay any money on the Preference Share; you would simply transfer your Note to the National as payment and then hold a fully paid Preference Share on which dividends may be payable. Dividends on the fully paid Preference Shares would be payable at the same rate, and on the same Terms and Conditions, as interest on the Notes.”

Further, there is more and this is what I think is important. Again from the 1999 prospectus:

“If interest is not payable for any particular quarter, you will not receive an interest payment for that quarter unless the National elects, at its option, to make up the payment. However, if the interest payment is not made or made up, the National will not be permitted to pay dividends on ordinary shares or securities ranking equally with National Income Securities until four consecutive interest payments are made. If the Preference Shares become fully paid, the payment of dividends will be subject to the same terms and conditions.

So what does that mean and why is it important?

Well to my eye it means that NABHA could well have a destabilising effect on a capital raising of NAB in the event of a dramatic economic downturn. For instance, in a deep recession it may well mean that NAB may not be able to pay interest on NABHA. Should this be the case, then dividends would not be payable on either the ordinary shares or the recently issued convertible preference shares (for they are equally ranking) for at least a year. NABHA holders would have to receive four clear quarterly payments before dividends could be paid. Further, if the bank was attempting or required to raise ordinary capital to bolster its Tier 1 capital it may see its shares heavily discounted due to the inability to declare a dividend given the explicit terms of NABHA. Indeed, we may have a conversion event triggered so that the recently issued NABPA convert at the worst possible time their holders. 

Now NAB may claim this is a remote possibility and that it would rectify a non-payment of interest to stop such a course of events. However, as I noted earlier, the events that are transpiring in Cyprus are taking the world into areas that were not previously thought possible.

All of this leads me to me speculate that maybe the NABHA are rapidly losing their usefulness as capital for NAB. We have recently seen the redemption of similar securities issued by the Bank of Queensland, and holders of NABHA should be aware of the possibility of redemption. This is particularly possible at a time when the NAB is well and fully capitalised (as at present). Clearly it would be better for NAB to clean up these securities when capital ratios are strong than to be forced to do so when capital is short.

All of the above leaves me as a holder of the obscure NABHA.

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

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Portfolio Details

Return since June 30, 2012: 23.67%

Returns since Inception (April 24, 2012): 22.43%

Average Yield: 7.72%

Start Value: $118,757.19

Current Value: $146,871.49

Dividends accrued since December 31, 2012: $2,053.22