Woolies hybrid has the WOW factor

PORTFOLIO POINT: Investors have rushed Woolworths' attractive hybrid, but only those retail investors who already own stock will be eligible.

Woolworths’ hybrid issue has been so popular that only a limited number of retail investors will get an allotment, but the hybrid is worth examining both for its qualities and as a hopeful sign of things to come for local investors.

The retail allocation opened on Thursday and the prospectus named a headline yield of 8.05%. Lincoln Indicators analyst Loago Madigele says the deal looks like a good one.

Due to huge demand from institutional investors starved of quality corporate debt, Woolworths finance director Tom Pockett said this week the company would lift the Notes II issue from $500 million to $700 million, and that just $25 million of that would be allocated to retail shareholders. None will go to retail investors who don’t own the stock.

This is something of a blow to retail investors who, since 2008, have started to realise that bonds and hybrids can be good counterpoint to equities but, as UBS vice chairman of wealth management Clark Morgan says, it could be the start of a raft of attractive corporate issues.

The real yield on the notes is about 5% once tax is taken into consideration.

The notes have a minimum investment of $5000 (which can be increased in $1000 increments) and a 25-year term, although Woolworths can redeem them after five years. The coupon, or interest on the note, steps up 1% after five years so the company has a motivation to redeem them after the five-year mark.

-Woolworths Notes II (WOWHC)
Key dates
Opening	Oct-26
Closing (shareholder offer)	Nov-17
Closing (broker firm offer)	Nov-23
Issue	Nov-24
Commence trading on ASX (deferred settlement)	Nov-25
Normal trading	Nov-30
First interest payment	Feb 24, 2012
Step up	Nov 24, 2016
Final maturity	Nov 24, 2036

However, with the real possibility of interest rates falling, there is a likelihood that the coupon on the hybrid will also fall, Madigele says. “Because it’s a floating rate [4.80%] plus a margin [3.25% over the bank bill rate] then you also see the possibility of your income stream actually declining.”

Still, Madigele says the hybrid has an advantage over a dividend because it is cumulative. “It means that if Woolworths doesn’t pay it [the interest] in any quarter, whatever income you miss in that quarter you won’t totally miss, it’ll actually be added to your future income streams from the company, whereas with a dividend, it’s at the complete discretion of the board.”

Any postponed payments have to be paid within five years of the first deferral, and if Woolworths breaches this rule it isn’t allowed to pay any dividends to shareholders until it pays the hybrid’s coupon. This would be a severe blow for the company, not only because Woolworths would lose its investment-grade credit rating but because part of the stock’s attraction is the 6.7% fully franked dividend yield, as noted by Matthew Koroi in 12 top dividend stocks.

Clark Morgan of UBS says other companies are likely to start thinking about issuing hybrids and corporate bonds to raise capital after seeing Woolworths' success.

The highest quality, best prepared companies will be the first cabs off the rank, but investors need to do their homework and a good place to start is by looking at the yield and the credit rating of a company.

“Investors certainly need to look at the creditworthiness of the issuing company; they need to look at where the instrument may fit in their portfolio and make sure that the performance characteristics and likely returns are in line with what they’re looking for,” Morgan says.

“It gets back to simple risk/reward equation: making sure that you’re adequately compensated for the risk you take on, which gets back to assessing the credit rating '¦ A hybrid is going to perform like a fixed interest instrument, not like an equity.”

Investors should be prepared for future issues if this one has piqued their interest, as the vastly diminished retail allocation and Woolworths’ decision to favour institutions over its shareholders won’t put others off. “When people think about investment and maximising returns they tend not do so because they got their nose out of joint '¦ They won’t turn around and shun the opportunity; if it meets their investment needs they will seek to get more exposure.”