Nothing new in AMP and NAB hybrids

(This article originally appeared on our sister site, Intelligent Investor Super Advisor.)

It’s been a while between drinks, but NAB and AMP have the advisors back on the phones selling two new hybrid issues – NAB CPS 2 and AMP Sub Notes 2. Nothing much has changed since Super Adviser's last hybrid review: the margins, terms and risk are more or less the same as earlier offers.

If you’re considering NAB CPS 2, we recommend a read of our earlier reviews of ANZ Capital Notes and NAB CPS. But if it’s an AMP Sub Notes 2 prospectus that’s landed in your inbox, take a look at our review of Westpac Sub Notes 2.

Apart from a few points of detail (and, in the case, of AMP Sub Notes, a different, and slightly less creditworthy, issuer), the latest offers are no different to the earlier versions. So, rather than repeat ourselves here, we’ll focus on whether these hybrids have a place in Intelligent Investor Super Advisor's model portfolios. But first, a quick review.

Table 1 compares the key features of NAB CPS 2 and AMP Sub Notes 2 to earlier hybrid offerings. As is standard these days, they’ve both got the (still undefined) Non-Viability Trigger Event (discussed in detail in Suncorp Sub Notes: one for the contortionists) and can be written off completely if conversion isn’t able to occur.

These features, together with the non-compulsory nature of the dividend and interest payments, and the cap on conversion are important. They highlight the fact these products aren’t fixed interest securities (which put an obligation on issuers to pay interest and repay principal). The NAB CPS 2 are complicated quasi-equity securities with debt-like features and the AMP Sub Notes 2 are quasi-debt securities with equity-like features.

Allocating the hybrids

Where do you fit such securities into an investment portfolio? As they’re typically pitched to conservative income-focused investors, we’ll use our Conservative Portfolio as a case study.

The target asset allocation for our Conservative Portfolio is set out in Chart 1. As you can see we don’t have a target allocation for hybrids, junk bonds or quasi-equities with debt-like features. We suspect the average investor is in the same boat.

Investing is complicated enough without having a ‘funky structured products or other esoteric investments’ asset class. So let’s consider them in the context of the asset classes we’ve got. Where do they fit?

We take a risk-based approach to asset allocation and, in particular, we aim to keep our fixed interest and cash ‘safe’. Risk is for the growth part of the portfolio (shares, property and infrastructure and other).

If we had to allocate hybrids to one asset class it would be ‘Australian shares’ (although you could mount an argument for ‘property and infrastructure’ given their relatively fixed return and the exposure of the finance sector to residential property). It’s a conservative way to tackle the issue and avoids us mistaking the risk on NAB CPS 2 for that of a low-risk Government guaranteed deposit or other highly rated debt security. They’re just not safe enough for us to allocate to ‘Australian fixed interest’.

Looked at from this perspective, it’s easy to give them the flick. Unless there’s a sudden spike in interest rates, NAB CPS 2 is offering a return of less than 6% and AMP Sub Notes 2 less than 5.5%. We’d hope to do better out of our shares and other risk assets than that.

Splitting them up

That’s a simple approach but we can get a bit more scientific, since these hybrids, whilst lacking some key ingredients of fixed interest, generally aren’t as risky as ordinary shares. So it makes sense to split them between the two asset classes. How should we go about this task?

It’s more art (or guesswork) than science, since so much depends on your point of view when it comes to assessing hybrids. During the global financial crisis, the market for many of the bank hybrids found a floor at around 60% of their issue price (see Chart 2) and, if NAB skipped the dividend payments on NAB CPS 2, the present value of the conversion proceeds (assuming mandatory conversion occurs) is also around 60% of the face value. Add in a touch of conservatism and we’d allocate 50% of the NAB CPS 2 to fixed interest – the rest (the ‘equity piece’) we’d allocate to shares.

The AMP Sub Notes 2 are a safer security (hence their lower return) so we’d allocate a larger amount to fixed interest. As we explained in Suncorp Sub Notes: one for the contortionists, these new sub notes are a very strange security, so it’s hard to know how much should be regarded as ‘safe’. We’d plump for a two thirds allocation to ‘fixed interest’ (refer Table 2) but we could be convinced that it should be, say, 75%. Either way, it doesn’t have much impact on our analysis below.

Now that we’ve allocated the hybrids to the two asset classes, we can allocate part of the return to each component. Each security will ‘mature’ in seven to ten years (although they can be sold daily on the sharemarket) and pays interest (or dividends) based on a floating rate. They’ve got elements of our Conservative Portfolio’s longer-term deposits and bond fund (the nominal length of the commitment), and our floating rate online savings account (the variable interest rate and ability to sell daily). On the ‘safe’ part of our portfolio we earn about 4.5%, so we’ll allocate 4.5% of each hybrid’s total return to fixed interest.

Having done that, we can then do the calculations set out in Table 3. Effectively, we’re back-solving to work out a return for the equity element of each instrument. Normally hybrids end up being analysed as a high-return fixed interest security (the approach used by many advisors) or a low-return risk asset (our simple approach above). But splitting them up means we end up with a boring fixed interest piece and an equity piece that looks a bit more interesting – the equity piece of each hybrid returns around 7% a year. But is it interesting enough?

Keep in mind that the 7% return isn’t set in stone. Interest rates will move it around a bit, but they’ll also help our short-term fixed interest and, if they’re in response to stronger growth, our shares may have performed strongly. So we’ll stick with 7% as our assumed rate of return.

The end result is that the equity piece of the hybrid doesn’t look diabolically bad, but it’s not terribly exciting either. Our boring property and infrastructure investments – for instance, Sydney Airport, ALE Property Group and BWP Trust – yield over 6% today, and we’d expect this figure to grow over time, with earnings and price growth included.

Our Australian shares on the other hand might be more volatile (and possibly more risky) but we’d hope, with some of Australia’s best stock pickers on the job, we’d do much better than 7%. For instance, Intelligent Investors Share Advisor's Growth and Income portfolios have returned, on average, more than 11% a year since inception.

So, to put it in a nutshell, instead of investing $100 in the NAB CPS, we’d put $50 into our current fixed interest investments and the other $50 into our Australian shares (or property and infrastructure) investments. That way we know we’ve got half that’s actually safe (not just an allocation to safe) and half that has the potential for growth and attractive long term returns, albeit with a degree of risk.

Potential pitfall

The one disadvantage in this approach (compared to investing $100 in a hybrid) is that the $50 invested in growth assets will pay us an unknown (possibly negative) return. On the other hand (assuming interest rates don’t change and the issuer doesn’t strike trouble) we know, more or less, what the hybrid is going to pay.

This is a key part of the attraction of hybrids for retail investors nervous about sharemarket volatility. But we’re focused on what we’re giving up if we invest in hybrids (our opportunity cost) and that’s why we give them the flick at today’s prices. If hybrid prices fell, pushing returns higher, we might reconsider that position.

Final word on hybrids

Whether we use the simple approach (treating hybrids as a risk asset), or split them in two, the end result is that the returns aren’t compelling compared to our current investments. Hybrid returns look attractive compared to term deposits, or low-risk bond funds, but that’s simply because investors aren’t factoring in the significant added risk.

When we add risk to our Conservative Portfolio it will be because we’ve identified an opportunity (and value), not because a broker’s email happened to land in our inbox.

(This article originally appeared on our sister site, Intelligent Investor Super Advisor.)