The hybrids threat to retail investors

It seems that 2016 is likely to go down as the year in which institutional investors became much more interested in hybrid notes. Increased institutional issuance in hybrid notes is likely to have both positive and negative implications for retail investors.

The trend appears to have started with Macquarie Group's Capital Notes 2 issue, which listed on the ASX in December last year. Macquarie advised the ASX of the top 20 noteholders when trading in the notes commenced.

AMP's Capital Notes issue also commenced trading on the ASX at around the same time but no advice was provided on the top 20 holders of AMP's $268 million of Capital Notes. It was the same when Westpac's $1.3 billion of Capital Notes 3 commenced trading in September.

This suggests that for both issues there were no individual holdings of any significant size. But in Macquarie's case the top 20 listing revealed that institutional investors had taken up just over 20 per cent of the $531m Capital Notes 2 issue. And the largest investor acquired a holding of 3.2 per cent of the notes issued.

But this is small beer in comparison to the levels of institutions investor participation in the hybrid issues seen so far this year.

CBA was first to market in March with its $1.45bn, PERLS VIII issue. The Top 20 listing released by the CBA showed that institutional investors took up more than 36 per cent of the issue and the largest investor acquired almost 20 per cent.

The figure for the subsequent issues from Westpac and NAB are similar.

Westpac's $1.7bn Capital Notes 4 issue saw the Top 20 holders account for 35 per cent of the issue and the largest 17.6 per cent. In NAB's case, the top 20 holders account for more than 38 per cent of its $1.5bn Capital Notes 2 issue and the largest holder more than 20 per cent.

The use of nominee companies by institutional investors disguises who holds the beneficial interest in the notes acquired but, interestingly, it is the same nominee company and account that holds the largest interest in all three issues undertaken so far this year.

The good news for retail investors is that institutional participation at these levels signals that the professionals now see value in the hybrid issues that have come to market this year. This may be attributed to the sell-off seen in the market last year or it may just be a reflection of the dismal lack of yield available anywhere else.

But this may be the only good news there is.

The hybrid market is a relatively illiquid market in comparison to the share market and even the wholesale bond market. Institutional participation at up to $300m a pop, as in the case of the NAB Capital Notes 2, will see the secondary market price of the notes hammered when the institution decides to sell down or even exit entirely.

Institutional investor participation at these levels also suggests that the time is fast approaching when hybrid issuance can switch to the wholesale market, just as subordinated debt issuance did in 2014. There has been no retail subordinated debt issuance from the banking sector since 2013.

Wholesale issuance of hybrid notes has occurred before. AMP sold $275m of hybrid notes in the wholesale market in March 2015 but the view at the time was that the size of the issue reflected limited institutional demand.

But now if one investor is fronting up to take $300m at a time, then institutional demand has increased significantly and 'wholesale issuance only' may not be far away. It will certainly be cheaper for issuers to go down this path and it may even allow regulators, such as ASIC, to sleep more comfortably at night.

Philip Bayley is an independent consultant to debt capital market participants and is associated with Australia Ratings.