Historically, bank hybrids were a small part of the retail investor universe. Most investors had heard of them but were not directly involved due to it being dominated by the institutional market. In the last five years this has all changed, primarily as a result of new bank regulation. The growth in this market size has been astounding and currently stands at over $21 billion.
Our analysis suggests that retail investors are now by far the largest investors in this space. When looking at the shareholder distribution statistics (on the back of annual reports) it is clear that holders of these instruments with between 1 and 1000 shares represent ~90 per cent of this market. This is at odds with common equity from the same issuers where the same distribution bucket represents approximately 55 per cent. Therefore we can make a reasonable assumption that institutional investors are no longer involved in this market in any meaningful way. The big question is why have institutions avoided it?
The answer to that question is uncertainty. Restrictions on fund mandates, fair value concerns and the simple inability to hold equity are all part of this uncertainty but the primary issue is that the structure of these securities is untested so there is no precedent for how they will perform. This makes it very difficult to build meaningful risk measures.
In the past week, the precedent question has been partially answered. An independent credit research firm released a note suggesting Deutsche Bank may struggle to pay interest on their hybrids next year if operating results disappoint or litigation costs are higher than expected. This resulted in a sharp selloff in the security and a quick reaction by management to refute the claim.
While this clearly demonstrates the fragility of institutional investment in this sector what does it mean to individual investors who dominate the Australian market?
First of all, the European bank hybrids (technically known as Contingent Convertibles or CoCos) are a different beast to Australian bank hybrids. The differences are plenty but the first point of price weakness is common across both. That is discretionary interest payments.
CoCos typically allow a bank to stop interest payments when it runs into trouble, like when its capital ratios breach levels considered dangerous (that’s the contingent part). If the bank’s financial health deteriorates further, CoCos can force losses on holders of these securities. The securities can lose their value entirely or convert into common stock (that’s the “convertible” part).
How do banks determine whether they can pay the interest due on a hybrid?
This is where it gets really technical. To make optional payments such as dividends, staff bonuses and coupons on CoCos, the European banks must calculate their “available distributable items". Deutsche Bank, which has to make the calculation based on its audited, unconsolidated accounts under German generally accepted accounting principles (GAAP), has thinner coverage than many other major banks. This prompted the current volatility.
Australian bank hybrids are not subject to the same condition and actually provide protection to hybrid holders in the form of “dividend stoppers”. These enforce restrictions on paying any dividends on common equity if there is a restriction on hybrid distributions. In the case of the Commonwealth Bank of Australia, investors would be prevented from declaring any dividends, returning capital or undertaking any buybacks without being approved by at least 75 per cent of PERLS VII security holders. This creates a huge incentive for management to keep paying distributions on the hybrids.
So, should Australian bank hybrid investors be concerned about an Australian bank not being able to pay the interest due on a hybrid? Look at how the Deutsche Bank and the Commonwealth Bank are positioned to meet these obligations. Examining their respective operating results is a good place to start and puts some context into the example. On January 28 2016, Deutsche Bank posted a posted a €6.8bn loss for the full year 2015, whereas CBA reported a $4.8bn first half profit two weeks later.
The major difference between the two is that Deutsche Bank has paid more than $US9.3bn in fines and legal settlements over the past 8 years due to settlements relating to violations of US sanctions, manipulating interest-rate benchmarks and currency rigging. While our banks have their own issues in relation to interest rate manipulation, the litigation costs are negligible compared to those paid by Deutsche to date. This gives us confidence that interest payments on bank hybrid securities do not appear to be at risk and although the bank hybrid market has experienced volatility in the past year there has been absolutely no suggestion that the Australian banks are about to stop paying interest on their issued hybrids.
Figure 1. Average Major Australian Bank Tier 1 hybrid Trading Margins since 2006
Source: Bond Adviser, as of 29 January, 2016.
Nicholas Yaxley is head of research at Bond Adviser.