Avoid Westpac Capital Notes 3

Westpac's latest hybrid securities aren't bonds, aren't stock, and they aren't worth investing in.

Let’s take a trip down crazy lane, shall we, and pretend for a moment that the banks are only looking out for themselves. Imagine, for the sake of argument—and not because this could possibly be true—that they are trying to reduce their own financing costs and risk, rather than doing their best to make you rich.

If that were the case, how might they do it? They could start by offering you a 136-page prospectus for complex ‘hybrid’ securities, then name them Westpac Capital Notes 3 to provide a warm feeling of continuity.

They would make the securities look and feel safe, like a bond, but ensure that the fine print says “Payments of Distributions are within the absolute discretion of Westpac” (ASX:WBC).

Then, they would make the Notes perpetual without a fixed maturity date, so the bank is under no obligation to ever give you your capital back or convert your loan into ordinary shares, which would allow you to participate in any increase in the bank’s profitability and see capital gains. It goes without saying that Westpac would also want you to be stuck with a lower distribution if the Reserve Bank were to cut interest rates again.

Furthermore, Westpac would want the option to redeem the securities after five years if it happens to find more attractive financing  though that’s probably unlikely given the only reason the banks are tripping over themselves to sell the hybrids today is because they’re such a one-sided bet.

And if Westpac were only looking out for itself, it would certainly want to make sure it gets the better deal in times of crisis.

Westpac could say the Notes rank ahead of shares should the bank be wound up, but the Notes should convert to equity for Westpac to draw on if its finances do actually deteriorate. If, let's say, Westpac’s Common Equity Capital Ratio, which is currently around 8.7%, fell to 5.125% or less, you'd want the Notes to immediately convert to Westpac shares and no longer offer any seniority in a wind up.

However, and despite the hybrids being so 'feature-rich', Westpac would still need to offer mum and dad something extra, or they’ll never throw their money away. So how about a margin of 44.2% over the 90 day bank bill rate, which is currently 2.1%, for a total distribution of 4.3% (after the 30% corporate tax rate is paid).

If you were Westpac and trying to gouge mum and dad, you’d design Notes with a yield that looks attractive next to term deposit rates, but then ensure the Notes act like fixed income securities in good times (minimal capital gains) and act like stocks in bad times (large capital losses).

Which is exactly what Westpac has done.

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