NAB Sub Notes: At sea and no lifejacket

In Ireland, investors in products such as this lost three quarters of their capital. NAB’s offer may be the best of the sector but for an extra 1% is it really worth the risk?

Key Points

  • More attractive than convertible preference shares such as ANZ CPS3 or Westpac CPS
  • Margin is not sufficient compensation for additional risk
  • Investors can learn from overseas experience

Those Intelligent Investor members who read the review of ANZ’s Subordinated Notes offer (Avoid - $100) from 20 Feb 11, will have a fair idea of what’s coming. They were not fans. And nor are we fans of NAB’s copycat offer, despite it being the best of a poor crop.

The product

Investing in hybrids such as this appears a safe, secure activity but right at the moment you need these qualities, they sink without trace. The experience of overseas investors in similar products (more on that later), shows how these products can go wrong and the disastrous consequences.

NAB is seeking to raise $1bn from this offer, although it has reserved the right to raise more. How much will depend on the number of investors willing to throw caution to the wind in the chase for meagre additional returns.

The NAB Sub Notes are identical in all material respects to the ANZ Sub Notes. Table 1 highlights the similarities and differences between these two products and ANZ CPS3. The key details are as follows:

  • Stated 10-year maturity with an early call right at five years
  • Margin (over floating 90-day bank bill rate) of 2.75%
  • Compulsory interest payments (except if NAB is, or would become, insolvent)
  • No step-up margin
  NAB Sub Notes ANZ Sub Notes ANZ CPS3
Table 1: NAB Sub Notes vs ANZ Sub Notes vs ANZ CPS3
Price $100 $100.50 $98.50
Official ranking Unsecured, subordinated Unsecured, subordinated Preference shares, convertible to ordinary shares
Risk characteristics Debt-like Debt-like Equity-like
Distribution rate 3 mth BBR 2.75% 3 mth BBR 2.75% 6 mth BBR 3.1%
Distribution type Cash Cash Cash franking credits
Compulsory distributions? Yes - subject to solvency Yes - subject to solvency No
Cumulative? Yes (if solvency test applies) No No
Principal repayment Cash Cash ANZ shares
Maturity date 18/06/2022* 14/06/2022* 01/09/2019
Yield to maturity# 3 mth BBR 2.75% 3 mth BBR 3% 6 mth BBR 3.9%
* NAB and ANZ have right to redeem early - NAB, from 18 June 2017 and ANZ, from 14 June 2017.
# Yield to maturity calculates expected annual total return for someone purchasing at today's price

The ‘compulsory payment’ term is an interesting twist on the definition of compulsory. The advantage of being a lender is that you can seek to have a company wound-up (and its assets sold) if the company is unable to pay its debts.

Holders of NAB Sub Notes can enforce their claim and seek a winding up unless NAB is unable to pay its debts. Yes, you read that correctly. You can only exercise your rights when there would be no point in doing so. This is the financial equivalent of a lifejacket you can use anywhere, anytime, except on water.

Does a margin of 2.75% (or 1-2% over term deposits) justify taking to sea with your lifejacket left on the jetty?

The returns

Those who have read our earlier reviews will know the answer. It’s a resounding ‘No’. If you’re of the mind that the Australian banking sector is impregnable (and we’re not) then buy the ordinary shares on a 10-11% yield (grossed-up for franking credits).

If you are worried about the undiversified nature of the banks’ balance sheets and their heavy reliance on foreign borrowing, then stick with Government Guaranteed term deposits. If you sit somewhere between these two extremes, consider a bit of both.

An investment consisting of 75% five-year term deposits and 25% bank shares will yield around 7%p.a. (again, grossed-up). Yes, a quarter of your investment may move down (or up) with movements in bank share prices (and your dividends are at risk), but the remainder is Government guaranteed.

Irish case study

If you find the idea of NAB Sub Note holders suffering losses a little far-fetched, consider the example of Allied Irish Bank, the second largest lender in Ireland.

AIB, like its fellow Irish banks, fell victim to a lack of balance sheet diversification or, more specifically, over-exposure to property. Yes, the bank had a ‘liquidity issue’, but so did every other bank in the world at the time.

When the problem hit, the Irish Government injected billions in additional capital to keep the ship afloat. And to whom did it turn to help share the burden? The Irish Finance Minister explains it best:

The Government’s announcement of 31st March set out that the Government will take all the steps it can to reduce the high level of capital required by the financial institutions from the taxpayer. Today’s action is intended to ensure that AIB’s subordinated debt holders share the burden of the capital position of AIB and reduce the level of capital sought from the taxpayer.

Micheal Noonan TD, Minister for Finance

The subordinated note holders were asked to sacrifice the bulk of their investments. No chance to enforce their claims; little chance to do anything much at all in fact, except wait or sell on market at a massive loss. Meanwhile, the Government worked to protect senior debt holders by threatening subordinated note holders with a range of measures to convince them to accept a ‘voluntary offer’ that paid them 10-25% of their principal.

Table 2: Key dates
Announcement of margin 21 May 12
Offer opens 21 May 12
Securityholder and general offers close 08 Jun 12
Broker firm and institutional offers close 15 Jun 12
Issue of NAB subordinated notes 18 Jun 12
Commencement of deferred settlement trading 19 Jun 12
Dispatch of holding statements 21 Jun 12
Commencement of normal settlement trading 22 Jun 12
First interest payment date 18 Sep 12
First optional redemption date 18 Jun 17
Maturity date 18 Jun 22
Source: NAB Subordinated Notes offer document dated
14 May 2012

And the lesson for potential NAB Sub Note buyers and other hybrid investors?

You may collect an extra 1% or so while the going is good. But if the good ship ‘Aussie banking system’ ever hits rocky waters and strikes a leak then, as with the Irish, you’re in the direct firing line of bank management, regulators and senior lenders. Chances are, you’ll get screwed.

Which is of course the point. Hybrids such as this aren’t designed to improve the earnings of income investors; they’re issued to protect depositors and other senior lenders. Why seek out an additional 1% in interest and risk your entire investment on a security designed to protect the capital of others?

The verdict

Whilst NAB Sub Notes don’t have the same potential for capital destruction as other hybrids–ANZ CPS3, Westpac CPS and Colonial Notes for example–we aren’t fans of the meagre returns.

There’s also a strong case that the banks will start marketing more attractive offers in order to meet the new capital requirements in Basel III, alongside maintaining their funding and preventing the residential property market sliding into the abyss. The quality of offers such as these should improve as that reality starts to unfold.

If you can’t resist the hybrid pitch, NAB Subordinated Notes are an improvement on other bank hybrids. If they seduce you, be aware that Intelligent Investor recommends total bank exposure (shares plus hybrids) be kept below a 10% portfolio limit. Otherwise give this offer a pass.

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