APA and Crown Sub Notes a hard sell

‘Everything old is new again’ sang Peter Allen. Nowhere is this more true than in the world of finance. The latest subordinated note issues by APA Group and Crown, hot on the heels of Caltex Sub Notes, prove it.

The banks—hungry for capital ahead of the Basel III reforms—led the early charge. Now corporates in need of cash to fund acquisitions, expansions and restructurings have their hand out. It’s a little like the junk bond days of the 1980s, when Michael Milken and his gang at Drexel Burnham Lambert were funding hostile takeovers with high yield bond offerings.

The market’s rejection of the Seek Sub Note offer suggests things aren’t completely out of hand. Today’s version of the junk bond is also a slightly different beast—sub-standard debt in good quality issuers rather than standard debt issued by highly leveraged companies. The equity features in offers like APA and Crown Sub Notes also makes them less likely to bring down the issuer—not that this is much help to punters in these issues.

The Product

As Table 1 shows, the APA and Crown Sub Notes offers are almost identical, mimicking the Origin Notes offer reviewed in Origin Notes next in pipeline. The key points are:

• Stated maturity that most investors won’t be around to see (60 years)
• Slightly higher margin (over 90 day bank bills) than Origin Notes—4.5 to 4.7% for APA and 5% for Crown (each subject to bookbuild)
• Interest payments are deferrable at the issuer’s option
• Notes can be called (redeemed), at the issuer’s option, in the sixth year after issue (first call date)
• Step-up in margin of 1% only applies 20 years after the first call date

The first call date and the loss, at that time, of ratings agency ‘equity credit’, means these products are probably going to end up as five to six year securities. But this outcome is not guaranteed.

As we saw with Caltex Sub Notes, issuers are going out of their way to warn investors that they’re on the hook for any deterioration in the issuer’s credit or the market for hybrids generally—both APA and Crown have indicated that they intend for these types of notes to form part of their continuing capital management strategies. This means that, unless APA and Crown can issue replacement notes at a reasonable price, these notes may become a permanent part of their capital structure.

In a normal world, with greater risk aversion and higher interest rates, a six year security granting the issuer a free option to extend it to 25 years (and a further option to extend it to 60 years, at a cost) would be a tough sell. Not now.

Globally, there’s an insatiable demand for junk bonds and the high yields that accompany them. Yields on high yield US debt are near record lows. In Australia, the oversubscription for Caltex Notes shows income investors aren’t done yet.

There is a decent chance APA and Crown Sub Notes will be oversubscribed and list strongly, too. Weaned on bank sub notes at just under 3% margins, investors are getting a taste of even higher returns from corporate offers and don’t seem in the mood to focus on what might go wrong.

The analysis

Let’s get the easy one out of the way first. Does the potential for a small stag on listing justify a buy recommendation?

No. The hotter the high yield market gets, the greater the likelihood the fad will end badly, delivering opportunities for those prepared to bide their time. Recall that we were only able to make very attractive profits from the noughties batch of hybrid securities, including the Dexus RENTS, Goodman PLUS and SKIES, just to name a few, because we avoided the high issue prices when they were initially sold and then bought them at much lower prices after gullible investors had lost money.

Two very similar issues at once also increase the risk the stag profit won’t eventuate.

We suggested you avoid Origin Notes and see no reason why you should start investing in 60 year high yield debt, with equity downside, now. Let’s take a quick look at each of the offers just to be sure.

APA Group

APA Group suffers a gearing ratio of over 60% and interest cover of just over two times, but its asset base is largely regulated and earnings are stable. Our main concern is that it seems to be in an acquisitive mood—the sub note proceeds will most likely fund the acquisition of Hastings Diversified Utilities Fund—and the future APA Group may not necessarily look like it did in the past.

‘Capped equity’, as these sub notes are best thought of, paying 8% isn’t compelling.

Current APA Group securityholders with half an eye on the exit might make a case to switch from the stapled securities (which yield 7%) to the higher yielding sub notes but this probably applies only to SMSF investors (especially those in pension mode). As distributions on the stapled securities generally have a tax-deferred component, individuals on higher marginal tax rates are likely to get a higher after-tax yield on the stapled securities (depending on the future tax-deferred percentage).

As hybrids go, APA Sub Notes aren’t that bad. If we had to choose between this offer, Crown and Caltex, we’d pick APA. But all suffer from the fact that the risk falls on the downside. We’d want a much higher fixed return before signing up for an investment where the uncertain scenarios are all ugly. AVOID.

Crown

Crown is more like Origin than APA Group; lower leverage but a more volatile business. Like Origin, it is also planning significant future capital expenditure. This may well be good for ordinary shareholders, who get the upside, but not so good for high yield debt investors who will see only the downside part of this equation.

Crown’s major shareholder, Consolidated Press, has indicated that it intends to take up $100m of the $400m sub note issue. That sounds comforting but remember that Consolidated Press owns about half of Crown. Economically, it remains a net seller of (or ‘short’) the sub notes.

There is another concern with the Crown offer and that is the effectiveness of the dividend stopper—a key deterrent against the issuer exercising their option to defer interest payments.

The threat posed is one of degree. For widely held, publicly listed, capital hungry, regulated institutions (banks) the dividend stopper is a powerful threat. A bank ceasing to pay dividends would see its share price plummet, its ability to raise capital neutered, rollovers of its short term debt put at risk and, quite possibly, its survival brought into question.

As highlighted in Colonial Notes: A dark side pitch, the dividend stopper is much less of a threat to a wholly owned subsidiary, and probably less of a threat to a company like Crown, which is conservatively geared and backed by major shareholder Consolidated Press. The exercising of interest deferral rights don’t carry the same weight here as they might with the banks.

But if you’re on the Packer side of the deal—a net seller of the notes—who cares? We suggest you don’t fall for James’ head fake and pass on this offer. AVOID.

The verdict

Like the junk bond rush of the 1980s, today’s hybrid mania allows companies to get away with high yield debt where ordinary shares might have otherwise been the order of the day. The incorporation of equity features in the modern variant makes it a much safer game for issuers, but the downside risks have been cleverly shifted to investors.

There is a good chance there will be a time when these and earlier sub notes offer compelling value but right now they don’t. Bide your time and give these offers a miss.