Macquarie Notes: possible each-way bet

Macquarie Group might have been slow to the hybrid party, or simply biding their time till retail investors peaked in their generosity to issuers and disregard for risk. Either way, from Macquarie’s perspective, the timing of the issue of Macquarie Group Capital Notes is impeccable.

The notes are a carbon copy of the Westpac Capital Notes (see Westpac Capital Notes: A fresh face but the same old story on Intelligent Investor Super Adviser). Like the Westpac version, nothing turns on the fact they’re structured as notes and not preference shares, since distributions and repayments are voluntary. The only way you can rely on getting your capital back is via the mandatory conversion into ordinary shares.

The product

The terms of Macquarie’s Capital Notes are similar to Westpac Capital Notes and earlier convertible hybrids. Let’s recap and highlight the key ones:

1. Distributions. The notes are floating rate and will pay semi-annual cash distributions at a rate of 4% above the 180 day bank bill rate. The distributions can be franked but Macquarie has indicated that it only expects the franking rate to be 40%. This is good news: it means the cash distribution is higher than other hybrids (so less waiting on franking credit refunds).
2. Maturity. There is no set maturity but there is a mandatory conversion to (roughly, and subject to movements in the share price) $101 worth of ordinary shares in Macquarie Group (ASX code: MQG) after 8 years. However, Macquarie has the option of exchanging early (starting in June 2018) and may also redeem the notes for cash at this time if APRA approves.
3. Mandatory Conversion Conditions. The Mandatory Conversion Conditions require Macquarie Group ordinary shares to be trading higher than (roughly) half the price they are at when the notes are issued. If not, the mandatory conversion won’t occur and the notes will effectively become perpetual unless the conditions are satisfied (more on this point below).
4. Non-viability Trigger Event. Macquarie’s notes don’t have the Capital Trigger Event (Westpac Capital Notes do) but they retain the dreaded Non-viability Trigger Event. APRA still hasn’t defined what this means so, as with other hybrids containing this measure, there remains the risk that APRA says Macquarie is ‘non-viable’ earlier than anyone else would.
5. Maximum Conversion Number. For scheduled conversions, the Maximum Conversion Number is calculated based on 50% of the Macquarie Group share price on the date of issue of the notes. However, this falls to 20% on an early conversion caused by the Non-viability Trigger Event. As we explained in Suncorp CPS2: Hybrids change gear, this is a good thing as it increases the number of ordinary shares you’re able to receive on conversion. However, if Macquarie has been deemed ‘non-viable’, this measure is only likely to reduce your losses, not prevent them.
6. Write-off. Finally, don’t forget these hybrids can be written off completely if the Non-viability Trigger Event occurs and conversion isn’t possible.

Table 1 compares Macquarie’s Capital Notes to the Westpac version and the earlier Suncorp CPS2 and Bendigo CPS offers (which both trade at a similar margin based on their current prices).

Let’s take a look at a couple of important points.

The Macquarie Group share price issue

The recent strong run in Macquarie Group’s share price means the Capital Notes will be issued at a time when the stock is trading close to recent highs. Many of the earlier hybrids listed on the ASX were issued when share prices were much lower.

The consequence is that the share prices of the earlier issuers have to fall much further before hybrid investors need to start worrying about the Mandatory Conversion Conditions and the Maximum Conversion Number.

To take an example, CBA PERLS VI were issued when CBA was trading at around $56, so the share price would need to fall back to its early 2009 levels for mandatory conversion not to occur. On a conversion caused by one of the trigger events shareholders will get their $101 in ordinary shares (per note) unless the share price falls to levels last seen in the 1990s (which is possible in the circumstances of a trigger event).

The Macquarie Capital Notes don’t have the same buffer. If the Macquarie Group share price falls back to its late-2011 level the Mandatory Conversion Conditions won’t get satisfied and the notes will become perpetual. In the scheme of things it’s not that much of a fall and this added risk helps explain the 4% margin.

Sounds scary, but don’t go tossing the offering document in the bin just yet.

A possible angle

We’ve avoided all the hybrids so far and we’ll be doing the same with this one. We’re sticking to our guns on a sensible, diversified portfolio being a better long-term approach than chasing yield and getting underpaid for taking on risk.

But in Bank shares versus hybrids we highlighted how the strong run in bank share prices had increased the relative attractiveness of bank hybrids (compared to the ordinary shares). As a result, the hybrids offered an opportunity for yield hunters with a lot of bank exposure to lock in profits and reduce risk without completely sacrificing higher yields.

The case is even stronger with Macquarie. Firstly, the share price has had a great run since our buy recommendation on 5 Aug 11 (Strong Buy – $22.97). Secondly, unlike the big banks – whose ordinary shares still offer higher (grossed up) dividend yields than the hybrids – Macquarie’s hybrid is being issued at a distribution rate about the same (or even a touch higher) than the Macquarie Group ordinary shares (6.8% for the hybrid vs 6-7% for the ordinaries, grossed up).

So if you’re teetering on the edge of selling some Macquarie Group shares, the hybrids offer a chance to de-risk but keep the yield. You’ll sacrifice upside of course, and you’ve still got the risk of an extreme fall in the Macquarie Group share price (as noted above). It’s basically an ‘each-way bet’ compared to the alternative of switching to term deposits or lower yielding shares.

Summing up

Despite the Macquarie Group share price risk, there’s plenty of hybrids worse than Macquarie Group Capital Notes. If you’re dead keen on hybrids, a small stake in these holds more appeal than a stake in other high-margin hybrids – for instance, Healthscope Sub Notes II, MYOB Sub Notes or Crown Sub Notes.

Officially though, we continue to stay clear of the hybrid party and we recommend the same to members. AVOID.

Richard Livingston is managing director of Super Advisor, Intelligent Investor's sister publication providing insights into, and debunking the myths surrounding, the world of tax and self managed super fund (SMSF) investing. Share Advisor members can enjoy a free trial here.