NAB Sub Notes correspondence

As indicated in this month's 'In a Nutshell', our article 'NAB Sub Notes: At sea and no lifejacket' stirred up a bit of controversy.

In the interests of members seeing both sides of the story, I have provided a copy of an email from Sulieman Ravell, Managing Director of Wealth Focus, with his views on why we are wrong.

My responses/comments are in italics.

The main point I think this (and the previous Greg Hoffman/Marcus Padley debate) demonstrates is that these types of securities are far more subjective than your average security. They require you to take a view on what banks (and APRA) are likely to do in the face of 'unusual/optional clauses' in the documents, and what the regulator and government are likely to do if things get difficult. This is all uncharted territory in an Australian context.

 

EMAIL EXTRACT AND RESPONSES

 

Hello Richard

I have read your article on NABHB and felt compelled to respond. I felt it was a very poor article from a usually credible source, the Intelligent Investor. Can I suggest that you focus more on the specific risks of the issue as opposed to resorting to sensationalist journalism.

We are clearly not going to please everybody when criticizing new issues where brokers and advisors stand to earn fees. But our main aim is to ensure that investors are reviewing these products with their eyes wide open. In this regard we try to provoke serious thought about the issues.

The comparison to ANZ CPS3 and Westpac CPS is a non-event. These issues have conversion clauses meaning that in the event of the bank falling on hard times, will ensure that they convert to equity. As an investor in ANZHA (an almost identical offering to NAB Subordinated Notes), your capital position is bolstered by this conversion (as well as that of ANZPA and ANZPB). It would therefore made more sense to compare this issue to some of the more common hybrid issues such as ANZPA and CBAPA etc.

While I agree we could have compared to ANZPA, CBAPA or others, the comparison was simply in keeping with all earlier articles where we have compared new issues to the other recent hybrid issuance. The main comparison was to ANZHA (copycat offer/identical in all material respects) and the comparison to ANZ CPS3 and Westpac CPS was to say that the NAB Sub Notes were, in our view, a much better proposition. We had the same view on ANZHA (ANZ Sub Notes).

You highlight the Irish Banks to further sensationalise your article. I think you may have missed the memo that our banks are rated AA- by a refocused S&P and also a regulator who is relatively ahead of the risk curve. And if you want to trot out the old chestnut of over-valued Australian property, you may like to look at the contribution to NAB's profits from their business banking franchise.

We have been consistently making the point that the hybrids generally are not term deposits (despite others making this comparison). The AIB case study was another way of highlighting the difference. We weren't suggesting that NAB was about to become another AIB but we should also remember that AIB were (pre-GFC) the second largest lender in Ireland and highly rated (A I believe). They weren't some fly by night operation.

We also shouldn't lose sight of the fact the Australian banks remain short liquidity (reliant on foreign borrowings exceeding the Federal Government debt ceiling), overweight property, have recently been downgraded and trade on dividend yields of 11%. Some familiar with the sector, such as Mike Smith of ANZ, have also made much ado recently about their rising borrowing costs. Stress in the Australian banking sector is unlikely but it can't be ruled out as impossible or even highly improbable.

Finally, you mention the regulator (APRA). APRA's role in a crisis is to protect depositors (not hybrid investors or shareholders). The overseas experiences show that one way they achieve this is by forcing losses on hybrids and shares.

Marcus Padley made a very good analysis of the fixed income bonds and hybrids, he said, relative to institutional binds, they’re overvalued, but the lack of securities available to retail investors means they are likely to remain that way.

I have attached a link to the correspondence between Greg Hoffman and Marcus on this point (http://blog.intelligentinvestor.com.au/doddsville/why-marcus-padley-is-dead-wrong-on-note-issues/). I don't think I can add much to this debate other than refer again to the subjectivity of these instruments.

Investors face the challenge of earning an adequate rate of return without undue risk. Your suggested portfolio blend is perhaps the worst piece of financial advice that I have read this year. Using the last 12 months to stress test your suggestion of 75% on deposit, 25% in bank shares, results in a total return from NAB's ordinary equity of 0.42%. Please explain how this is constructive to income dependent investors who have little appetite for capital loss?

Firstly, let me be clear that I wasn't suggesting that anyone invest in NAB shares for the last 12 months.

Secondly, I don't see the case for someone who has little appetite for capital destruction switching from a Government Guaranteed (and APRA protected) term deposit to a security designed to be the 'sacrificial lamb' in a crisis.

Finally, where investors often come unstuck is by 'chasing yield' and then building a case to justify the chase (eg the entire sub-prime debacle). I believe this phenomena is well and truly at work here (Australian investors weren't exactly screaming out for sub debt prior to the 'hybrid party').

Our philosophical point was simply that, rather than chasing yield, investors should (a) work out whether they are believers in the banks business case, and (b) invest accordingly. Moving your entire investment from Government Guaranteed to 'at risk' for a relatively small return pick up just doesn't sit right with us. We believe conservative bank fans would be better off keeping the bulk of their capital completely safe and buying the yield/upside story with a small portion. And if they aren't fans just giving it a miss.

The point you continue to miss in your articles is that banks, through term deposits, are paying  historically high margins which will likely reduce under BASEL III regulations.

We don't see the trend of high margins on bank debt reversing anytime soon. The major bank CEOs have spent the last couple of years making this case.

The banks can't shrink their balance sheets without causing a property nightmare for themselves so they have to keep their $500b of term depositors and $300b of foreign lenders happy.

It's a shame that you write articles like this, angling for a reaction. Your equity coverage seems quite good but you just seem to lose the plot anytime you look at fixed interest. I would suggest that if you can’t provide a decent analysis in this area, you should stick with equities.

Regards

Sulieman

 

Sulieman Ravell

Managing Director

Wealth Focus Pty Ltd

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