The hybrids party isn't over

2012 will go down as the year in which retail investors learned about debt investing as an alternative to equities. But whether retail investors will ultimately find the experience rewarding, or a case of learning the hard way, remains to be seen.

A record $13 billion of debt securities were offered to retail investors in 2012. Out of this total, only $400 million was in the form of plain vanilla, senior ranking debt – the boring stuff on which you should expect your coupons to be paid on time and in full, and on which the principal can be expected to be repaid after five years or so.

The other $12.6 billion of debt securities offered to retail investors was in the form of riskier, to much riskier, subordinated debt and hybrid notes (which incorporate features of both debt and equity). These are much sexier instruments offering considerably higher yields.

In fact, ever-increasing yields were required to sell bonds, with ever-increasing risks over the course of the year. The MYOB bond issue completed just before Christmas set a new record, with a 10% coupon for the first 12 months and then a spread of 670bps over 90-day bank bills thereafter.

With investors eagerly snapping-up hybrid securities with deferrable, non-cumulative coupons and a maturity date in 2072, there is every chance that 2013 will see the launch of the first perpetual, zero coupon bond. As is the way with zero coupon bonds it will be issued at a deep discount, say 20 cents in the dollar, and combined with the promise of a 12% yield, if the issuer ever opts to redeem, should be sufficient to get it away.

However, the Australian Securities and Investments Commission is becoming concerned about the increasing risks that retail investors are being asked to bear and the Australian Taxation Office is said to be looking at the revenue being lost through the use of franking credits on coupon payments.

ASIC wants the distributors of complex products to test investor understanding of the risks involved before a sale is made. I humbly suggest that any such test should include the ability to correctly define the following terms: deferrable; non-cumulative; subordinated, lower Tier II, Additional Tier 1 Capital, loss absorption, bail-in, non-viability; written-off, zero coupon and perpetual.

Potential investors could also be asked to write a brief paragraph on why holding ordinary equity may be preferable to holding hybrid notes with any combination of these ‘features’ – although this probably wouldn’t do a lot for hybrid note sales.

In unverified reports over the new year period, the ATO is said to be taking a close look at the franked coupons paid on hybrid notes with a view to disallowing the franking credits. Any such action would be a tax event under the documentation of such issues and would allow the existing issuers to immediately redeem the affected hybrid notes.

Failure to redeem would result in an immediate 43% increase in the cost of servicing the notes. Admittedly, these costs should be recouped at a later date, with the real cost being one of timing differences.

Intending hybrid issuers would have to consider the changed economics of the instruments.

However, retail investors should not be concerned that the great subordinated and hybrid note issuance party is over. There is another regulator who is keen to ensure a steady supply of such issues.

From the start of this year, the Australian Prudential Regulation Authority wants all authorised deposit-taking institutions to maintain a minimum total capital ratio of 8% of risk-adjusted assets. Of this amount, at least 4.5% must be in the form of Common Equity Tier I Capital but 1.5% can be in the form of Additional Tier 1 Capital (hybrid notes) and 2% can be in the form of Tier II Capital (subordinated debt).

With both the hybrid and subordinated notes issued by ADIs required to be capable of loss absorption in need, and with this typically resulting in conversion to ordinary equity, many institutional investors will be prohibited from investing in the instruments. This means the ADIs will be looking to retail investors to take the risk, and they should pay accordingly.

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.