Drinking the hybrid Kool Aid

We've talked a lot about hybrids in recent times. This is simply because the Government attack on self funded retirees, through pushing down term deposit rates, is seeing many people taking a dabble in hybrids to replace lost income and others in a similar position wondering 'should I?'

This week's post is an article written by an expert in fixed interest products, and hybrid investor, Moray Vincent. Moray is director and co-owner of Structured Credit Research & Advisory, which advises wholesale/institutional clients. 

The article raises some key questions, the answers to which will be critical to the attractiveness and risk of hybrids (particularly the older style) going forward.

DRINKING THE HYBRID KOOL AID

Following the GFC, the thoughts of governments and regulators in the developed world are that the way to prevent another banking crisis is to ensure that banks hold more capital to absorb any future potential losses. This will be enforced through the Basel III proposals.

This has spawned a raft of new securities called Contingent Convertibles (or 'cocos' for short), as an alternative to simply issuing more ordinary shares with dilutive consequences. The 'cocos' convert to common equity if banks get into trouble effectively 'bailing-in' the bank, with investors taking the full pain for their bad investment decisions, rather than troubling the taxpayer with a 'bail-out'.

The market in the UK is so advanced that in mid-November Barclays issued a $3 billion, 10 year issue with a fixed coupon of 7.625% where principal is written down to zero if Barclay's tier 1 capital ratio falls below 7% (yes $3 billion wiped out completely and not even converted to shares). This issue did trade as high as $103 initially, but has now fallen back to $101.

In common with the mainly Asian retail investors that purchased the Barclays note, many Australian investors in bank hybrids potentially under-estimate the risk of a bank or other ADI getting into trouble and the government and regulators not riding to the rescue to save the bank and their investment with taxpayer dollars. The former might still happen, but not the latter.

Australian retail investors also seem to be holding to a stubborn belief that a bank will always 'keep faith' with them and continue to call and redeem preference shares and subordinated debt regardless of the economics. Australian investors may be aware that the world has changed, but not that the views of issuers and regulators (towards these instruments) is changing too. So the question is are Australian investors simply continuing to 'drink the Kool Aid'?

An illustrative local example is the recent decision by Bank of Queensland not to redeem its 2007 hybrid issue PEPs (BOQPC).  The note is perpetual, but the issuer had an option to redeem in December 2012 for par.   It makes no economic sense for BoQ to ever redeem this note as it pays a coupon of BBSW 2.00% on a grossed up basis, representing ridiculously cheap funding.  Even so, prior to BoQ's announcement, there was a high expectation priced into the notes that they would be paid out at par in December.

Instead of redemption, BoQ offered BOQPC holders the option to roll into their new hybrid BOQ Convertible Preference Shares (BOQPD), a Basel III complying 'coco'. Only holders of BOQPC prior to the 9 November were given the conversion option, preventing investors buying BOQPC at a discount as a cheap entry to BOQPD.  This leaves any investor purchasing BOQPC in the last month with potentially no exit other than selling to a 'greater fool than themselves' on market (so long as BOQ don't de-list the residual hybrids as they suggested).

BoQ's motivation is possibly two fold.    Firstly, by 'strongly encouraging' BOQPC holders into BOQPD, they avoid the risk of losing capital from their balance sheet as they could have with a redemption and new issue replacement.  Effectively BOQPC holders rolling over are underwriting the new BOQPD security.

The second and more interesting motivation is perhaps a message from the banks, and the regulator, APRA, to hybrid holders - If your security is a long way out of the money you should no longer expect the issuer to come riding to the rescue by providing a ridiculously uneconomic redemption for you at par.

The BOQ approach is a 'meet in the middle' strategy - a roll-over which sits somewhere between the old way of always 'keeping the faith' and the regime now operating in Europe of pure economics - a gentle word in the ear  of investors  'stop drinking the Kool Aid, it might be poisoned, the world is changing'.

One way of gauging the future direction will be BoQ's treatment of the residual BOQPC holders (those who either didn't or couldn't roll into BOQPD). These notes are still callable on the coupon dates of April and December and BoQ has a range of choices. At one extreme they could de-list the hybrids and simply send the holders their coupon payments for the rest of eternity but otherwise forget about them. The other extreme is BoQ redeems the issue on the next coupon date in April with the soft excuse they are simply cleaning up their balance sheet by getting rid of what has essentially become a nuisance issue to them.  There are a range of options in the middle.

If not redeemed, BOQPC is simply a stream of franked dividends totalling BBSW 2% for as long as BOQ decides (or is able) to pay them. This looks very similar to common equity whose theoretical price is simply the market's estimate of the present value of the future dividend stream. There are some differences but these are offsetting. On the negative side, BOQPC dividends won't grow if the bank does well unlike the expectation for ordinary shares. On the positive side, BOQPC holders enjoy a change of control clause - if BOQ is taken over they will most likely get their $100 back.

A quick calculation based on the PE ratios and dividend yields of the four major banks (a generous comparison as BOQ is a lesser institution) would suggest 10% as an appropriate risky discount rated for the BOQPC dividends in perpetuity. This gives a fair value for BOQPC of around $60. Others have valued it around $70 by reference to the trading margins on other perpetual hybrids—BENHB, MBLHB and SBKHB.

The latest trade at $87.10 seems to be factoring in a much greater chance of BOQ redeeming BOQPC than leaving it out there.   The two questions are:  Will investors keep drinking the Kool Aid and continue bidding in the $80's and $90's in the hope that BoQ eventually keeps the faith and redeems them at par?  And how will BOQ respond?

The answers will give some guidance for the ongoing perceptions and changing culture within the hybrid market and investors await with interest.

Disclosure: Moray owns hybrids not discussed in the article.