Westpac hybrid falls short of shares

Westpac is leading the hybrids charge in 2013, but its shares are paying more right now.

Summary: Westpac’s latest hybrid issue is paying above the 90-day bank bill rate, offering a pre-tax yield above 6%. But in comparison, the current prospective pre-tax yield on Westpac shares is 8.86%.
Key take-out: Banks are set to issue more hybrid securities this year as they move to top up their capital adequacy levels.
Key beneficiaries: General investors. Category: Income.

Westpac has announced a minimum $500 million hybrid note issue, with an optional March, 2019 redemption/transfer date and a scheduled conversion date two years later. This is the first hybrid note offering of 2013 and is likely to be quickly followed by an issue from NAB, according to market sources.

Further issuance by banks can be expected in 2013 as they move to shore-up their Additional Tier 1 Capital levels. Existing capital, that is not Basel III compliant, has already begun to amortise by 10% per annum, straight-line.

Westpac’s new hybrid notes feature the now standard terms and conditions for Basel III compliant Additional Tier 1 Capital, with deferrable, non-cumulative coupons and capital and non-viability mandatory conversion triggers. There is also the risk of a complete write-off of the notes if mandatory conversion into ordinary equity cannot be undertaken.

The compensation for these risks is a headline ‘high’ coupon rate. However, the headline rate of an indicated 320 basis points (bps) to 340bps over the 90-day bank bill rate falls well short of the 380bps over that CBA paid on its PERLS VI hybrid notes, issued only three months ago.

More will be said on relative value below.  But for now let’s focus on the risks.

Westpac correctly says that one reason for issuing the notes is to “help to protect Westpac’s depositors and other creditors by providing a loss absorbing capital buffer which supports losses that may be incurred on Westpac’s assets”.

Protect depositors are the key words in this statement.

Investors should not think that the government won’t allow Westpac to fail, and therefore their investment is not at risk. The revisions to bank capital adequacy rules introduced under Basel III, effective from the start of this year, were made in response to the events of the GFC and to ensure that governments (taxpayers) would not be required to bail-out failing banks in the future.

Under Basel III, all subordinated noteholders of a failing bank will be ‘bailed-in’ before any taxpayers’ funds are used to protect depositors. Depositors in a failing bank will be protected by government, at least to any guaranteed level.

Regulators are determined to ensure this message gets through to all subordinated noteholders. This is underlined by these hybrid notes being called Capital notes: ASIC’s favoured term, as it highlights the position of the notes in Westpac’s capital structure.

Further confirmation of the risk investors are taking is provided by Standard & Poor’s assigning a ‘BBB’ rating to the Capital notes.

This rating cannot be disclosed to retail investors by S&P or Westpac. Nevertheless, it should be noted that the ‘BBB’ rating is notched off the Stand Alone Credit Profile (SACP) of Westpac, which is assessed as ‘A’.

The SACP is effectively two notches below the ‘AA-’ senior debt rating assigned to Westpac, which factors in government support for depositors and senior debtholders.

Thus S&P recognises that no government support will be forthcoming for the holders of the Capital notes. Moreover, the ‘BBB’ rating assigned to the Capital notes is three notches below the SACP in recognition of the level of subordination borne by noteholders and the risks of coupon deferment and mandatory conversion into ordinary equity, at a time weakness.

That said, the probability of Westpac failing at the present time is low, although it should be remembered that both it and ANZ came close to failing during the “recession we had to have” in the early 1990s.

So, does the ‘high yield’ coupon offer good relative value?

The spread of 380bps offered on the CBA PERLS VI at the time of issue is largely irrelevant, as the notes are now trading around 295bps over: such has been the demand for these notes in the secondary market. However, this demand is hard to explain when ANZ’s CPS3 and Westpac’s own CPS, which are comparable hybrid notes, are trading at 320bps and 314bps over, respectively.

Given that the Westpac Capital notes have an optional redemption/transfer date that is 12 months later than that for its CPS, a wider spread is required. Moreover, investors often expect a new issue premium and that seems especially pertinent now that stockbrokers are saying a “great rotation” is underway, back into equities and away from fixed income assets.

Lastly, as previously observed, with hybrid notes having all the downside risks of equity and none of the upside, shares in the issuer will often offer investors a better risk-return profile. The Westpac Capital notes are offering a pre-tax yield of 6.2% to 6.4% for the first 90 days, the current prospective pre-tax yield on Westpac shares is 8.86% per annum.

Plus, there is the upside that will come from further investor rotation back into equities.

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.

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