Tuesday 26 August 2014 by Craig Swanger Opinion

FIIG Securities says new "bail-in" hybrids are equity risk, not fixed income

Today FIIG issued this note as a press release to the market. We are warning investors that the new breed of hybrid is not traditional fixed income, and in a downturn they will perform just like equities and not protect investors like fixed income should

Key points:
  1. The new breed of hybrid is not traditional fixed income, and in a downturn they will perform just like equities and not protect investors like fixed income should.
  2. Regulators are happy that these hybrids are “equity” because of their ability to force a conversion in a crisis; and investors, particularly private investors, price them like debt.
  3. The biggest risk is what happens when markets sense that a bank’s financial position is deteriorating toward a point where non-viability may be called by the regulator and investors start a sell down of the hybrids, which will occur well before any actual crisis triggering a non-viability clause.
  4. The UK’s financial services watchdog, the Financial Conduct Authority, this month banned the issue of bail-in hybrids to retail investors. The EU’s equivalent, the European Securities and Markets Authority, has flagged it is likely to follow.

Leading fixed income investment specialist FIIG Securities is warning investors that the new breed of hybrid is not traditional fixed income, and in a downturn they will perform just like equities and not protect investors like fixed income should.

FIIG Head of Markets, Craig Swanger, said “The problem with these hybrids is that they were specifically designed to provide financial support to banks if they have another financial crisis like the 2008/09 GFC. That is, they will convert to equity, without investor choice, at precisely the wrong time for investors. Many in the market believe the hybrids will only convert when the bank becomes bankrupt but this is not how the regulator views it, they see this capital converting when the bank is in trouble but still “a going concern” and investors in these new securities will likely take a significant haircut on their capital when they convert.”

“It is important to understand that these securities are designed to be equity in the eyes of the banking regulators. During the GFC, several European banks were bailed out by governments which in effect saved the banks failing but laid the burden of loss at both the equity holders’ door and taxpayers. Bond investors were protected (as they should be) because they ranked higher in the capital structure. In Australia the taxpayer was burdened with having to provide a deposit guarantee. If the same scenario played out today, the banking regulator would have the option of declaring non-viability and forcing a conversion of these hybrids to equity – good for the taxpayer but not so good for the hybrid investors.”

Now banking regulators are encouraging banks to issue more “Tier one” capital, i.e. “equity” to avoid a repeat of this scenario. But rather than issue expensive equity diluting existing equity holders, the banking sector designed these hybrids to take advantage of a market arbitrage. Regulators are happy that these hybrids are “equity” because of their ability to force a conversion in a crisis, and investors, particularly private investors, price them like debt.

Ironically, it is now the same regulators that are warning that the risks of these securities are not being properly priced. The Bank of England recently warned, “There is a risk that investors are underestimating the probability that [these] instruments will be required to absorb losses”. Then UK regulator, the Financial Conduct Authority, this month banned their issue to retail investors while the EU equivalent, the European Securities and Markets Authority, has flagged it is likely to follow.

“FIIG believes that the regulators’ proactive role is appropriate and timely. In Australia, where ASIC issued a similar warning over a year ago, the market is still focussed on the relatively minor risk of one of the Australian banks becoming “non-viable”. That is not the biggest risk facing holders of these hybrids.”

“The biggest risk is what happens when markets sense that a bank’s financial position is deteriorating toward a point where non-viability may be called by the regulator and investors start a sell down of the hybrids, which will occur well before any actual crisis triggering a non-viability clause.” Such a sell down occurred in 2008/09, when even the major banks’ hybrids dropped by more than 30% without any question of default of the banks. “What we don’t know yet is what will happen in the next financial crisis when these new bail-in hybrids are put to the test,” Swanger says. These new hybrids could fall much further than 30%, and potentially even more than equities if investors dump the hybrids ahead of conversion.

This sell down could occur sooner than many expect if ASIC were to follow the UK example and ban retail distribution. ASX data shows that large institutional involvement has fallen dramatically over recent years. Hybrid participation prior to 2008 was 60-70% institutional, but by 2013 this figure had fallen to 20%, meaning the participation of smaller investors would have made up the difference. SMSF industry data confirms this, showing that SMSFs are holding around $30bn in hybrids, up from less than $10bn in 2008.

“Fixed income is supposed to protect investors in a downturn and provide regular, reliable income throughout the cycle. Hybrids failed to offer protection in 2008/09, but the major banks’ bonds (without the bail-in provisions) fell just 2-3% and recovered immediately. Bank equities fell by 40% on average, but you accept that risk because you also have the chance for upside, as investors that held on to their bank stocks have now found. With these hybrids, you get neither the protection of bonds nor the upside of equities.”

“Since the global financial crisis, hybrid products have become more complex, more like equity and more popular than ever with SMSF investors. They are not fixed income in any traditional sense – they have no set maturity date, have optional interest payments and can be converted to shares by the banking regulator.”

“Furthermore, there are clear signs globally that professional investors are sceptical about the value these new hybrids offer. However private investors are still chasing yield, and without access to other investments offering security and high yield, will continue to support these hybrids. More transparency of the global debate and education is urgently needed.”

For its part in this, FIIG has issued a research paper on the topic titled “New style Basel III-compliant bank subordinated debt and Additional Tier 1 securities/hybrids are higher risk”.

ENDS: Media enquiries to Duncan Macfarlane on 0435 092 936

About bail-in hybrids

Bail-in hybrids (also known as Contingent Convertible securities or “CoCos”) were created in 2009 in the UK, when Lloyds Group issued a new type of hybrid. The securities would be automatically converted into shares in Lloyds in the event that Lloyds’s capital fell to crisis levels.

Rather than the government being forced into further bail outs, these new securities would convert from high-yielding hybrids into shares without the investor or even Lloyds itself having any choice in the matter. In other words, the hybrid investors would be “bailed-in” to prop up the bank’s balance sheet.

Since then, European banks have issued around $110 billion (€75billion) in these hybrids. Banks, and until recently regulators, have been pleased at the success of this financial innovation as it means bondholders and government bodies are far less likely to need to bail out banks in the event of a liquidity crisis like that seen in 2008.

Banks are particularly keen to issue more of these securities because they are a cheap source of funding. In a crisis, these securities act as a loss-absorber as banks don’t have to pay interest or repay the capital. For this reason, European banks are expected to issue a further $240 billion (€170billion) in the next two years. Yield hungry investors are expected to scramble for an allocation, with Deutsche Bank’s recent €1.5billion issue receiving €25billion in orders.

However, the tide is turning, with the UK’s financial services watchdog, the Financial Conduct Authority, this month banning the issue of CoCos to retail investors. The EU’s equivalent, the European Securities and Markets Authority, has flagged it is likely to follow.

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