Tread carefully with this hybrid

PORTFOLIO POINT: Rather than lending to the ANZ for eight years, perhaps you should just buy its shares.

Earlier this week ANZ broke ranks with the big four to launch the first major bank hybrid in more than two-and-a-half years. The $750 million capital raising will utilise a convertible preference share structure that will be known as the ANZ CPS3 and is expected to trade under the code ANZPC.

At first glance the hybrid will appear attractive to many investors – not least the yield, which compares well to other bank hybrids, as well as the franking credits on offer. Investors might want to consider the offer in more detail before making a commitment, however.

The basic details of the offer are this:

• ANZ is offering notes for $100 each that will pay two dividends a year, which are fully franked and expected to be at a rate of 3.1% a year above the 180-day bank bill swap rate.
• The hybrid notes will covert to $100 worth of ANZ shares on or before September 1, 2019, with a 1% discount on conversion.

With a current 180-day bank bill swap rate of about 4.6%, that would deliver investor a grossed-up yield of 7.7% (this figure includes franking credits). In reality this 7.7% return will be a 5.4% cash dividend that will be fully franked. Or, to put in another way, an investor will receive $5.40 in fully franked dividends for every CPS3 security they own.

The fact that dividend payments are linked to the 180-day bank bill swap rates makes the ANZ CPS3 a floating-rate investment, where the interest paid will change as rates in the economy change. This is great if interest rates rise, not so good if they fall.

Overall, a floating rate investment would be expected to have less price volatility as interest rates change than a fixed rate investment, as the interest rate paid always reflects current market rates (for more on floating rate notes, click here).

Putting to one side the fact that the CPS3 is promising yields about 50–80 basis points higher than existing bank hybrids, there are a couple of other comparisons we can make with this product that investors may find valuable. But before we do that, let’s look a little more carefully under the bonnet of this hybrid.

New regulatory standards from APRA issued in the aftermath of the GFC mean that bank issued hybrids need to meet a stricter range of guidelines. One stipulates that should the bank meet a “Common Equity Capital Trigger Event” then mandatory conversion of the hybrids into shares will not take place and investors will need to take a haircut.

The definition of a “Common Equity Capital Trigger Event” essentially boils down to a situation where the bank’s common equity ratio as defined by APRA falls below 5.125%. It has been suggested that for this to happen the bank’s shares would need to fall from yesterday’s close of $19.82 to below $10. If the share price fell to about $8 then CPS3 holders can expect to suffer a loss of about 20% on their investment.

The chances of this scenario unfolding are quite low. ANZ is an AA-rated bank (the same as the US government) and the chances of a share price collapse of this magnitude are unlikely but not impossible. The closest measure to APRA’s common equity ratio available to us right now is tier-one capital, currently 10.6%.

As unlikely as such an event is, it is still worth comparing to the position of the ANZ term deposit holder, who is afforded a range of protections and still achieves returns of about 6%. Although the 7.7% on offer via the CPS3 is a superior return the risks the hybrid investor exposes themselves to are considerable.

The term deposit, for example, has a known value and a finite term to maturity, whereas CPS3 notes can trade above or below the $100 issue price, creating a degree of uncertainty for investors and so add volatility in the secondary market.

At the same time, investors would be aware that ANZ shares are offering investors a historical dividend yield of 7% fully franked, or a gross yield (including franking credits) of 10%. That compares favourably with the CPS3 yield of about 7.7% gross. Sadly there is no such thing as a free lunch for the shareholder in this instance either, as the shares are likely to face even greater volatility than the hybrids.

Still, the question needs to be asked: if you are confident enough to lend money to ANZ for a period of up to eight years (which is what a CPS3 investor is doing) without the security afforded to a depositor, perhaps you should just buy ANZ shares with a 10% gross yield? Or, conversely, if you are not confident enough buying ANZ shares with a 10% gross yield, do you really want to lend ANZ money for up to eight years without the securities afforded to a bank depositor?

Conclusion

My personal opinion is that the cash and fixed interest parts of a portfolio should let investors sleep soundly at night. Highly rated bank deposits and true fixed interest investments rated AA or better are reliable investments that, in a portfolio, provide a crucial buffer to the volatility (shares) or liquidity problems (property) of growth assets.

Unlike true growth assets such as shares or property, CPS3 does not offer any significant chance of price growth or dividend/income growth over time. That said, a comparatively attractive, fully franked dividend stream will no doubt be what some investors are seeking.

It is also perhaps worth noting that ANZ has not sought a credit rating for the ANZ CPS3 investment. While credit ratings continue to be a topic of much conjecture after the GFC and following the US downgrade, my personal opinion is they remain a useful source of credit quality information for an investor.

-Key dates for the offer
Event	Date
Opening date	August 31, 2011
Closing date for security holder offer and general offer	5pm AEST, September 21, 2011
Issue date	September 28, 2011
CPS3 commence trading on ASX(unconditional deferred settlement basis)	September 29, 2011
CPS3 commence trading on ASX (normal settlement basis)	October 5, 2011
First six monthly dividend payment date	March 1, 2012
Mandatory conversion date	September 1, 2019

Scott Francis is an independent financial adviser based in Brisbane.