Avoid ANZ Capital Notes 3

When a banker offers you a hybrid security and 124-page prospectus, hold on to your wallet. Since all the hybrid securities we bought during the GFC have become overvalued, we've pretty much had a 'no hybrid' policy (see No NAB or AMP hybrids for this model portfolio). ANZ's latest Capital Notes 3 are no exception.

The 3.6-3.8% margin the Notes offer above the bank bill rate (currently 2.6%) looks appealing relative to term deposits and is far superior to the 2.8% margin offered by the most recent hybrid issue (see Commbank PERLS VII Capital Notes: Storm clouds brewing?). Nonetheless, it's still inadequate compensation for the risk.

Unlike deposits, the hybrids aren't guaranteed by the government so shouldn't be thought of as cash equivalents. The prospectus isn't joking when it says 'you would be one of the last classes of investors to be repaid, and so could lose your money'.

Another shortcoming is that unlike senior bonds, the Notes only pay distributions that are at 'ANZ's absolute discretion', and, unlike shares, have no claim on ANZ's future profits – which means next to no chance of capital gains.

The Notes are perpetual without a fixed maturity date, so you may not receive your capital back or ever have them converted to ordinary shares. If the Reserve Bank were to cut interest rates again, you'll be stuck with a lower distribution while ANZ shareholders may at least enjoy a jump in the share price.

You don't even get to rest easy in times of crisis. True, the Notes rank ahead of shares should ANZ be wound up. But the Notes have specifically been created to behave like equity for ANZ to draw on when its finances deteriorate. If ANZ's Common Equity Capital Ratio, which was 8.8% at 30 Sep 14, falls to 5.125% or less, the Notes immediately convert to ANZ shares and no longer offer any seniority in a wind up.

So what are we left with? Another set of hybrids that convert into equity – or are written off altogether – in various downside scenarios, all to gain an extra percentage point or so of yield...'at ANZ's absolute discretion'. AVOID