FIIG has been leading the fixed income industry’s debate about whether some of Australia’s hybrids are good value. At the core of our argument is the complexity that comes with the right of the banking regulator to convert these hybrids into equity, for example “bail-in” hybrid investors’ money, rather than have government “bail-outs”
But for many investors, the question is how to replace this income in their portfolio, without taking on more equity markets risk. This is particularly poignant at the moment as global equity markets seem nervous.
One area of the market that offers strong relative value at the moment is infrastructure debt. The chart below shows some examples of the infrastructure bonds our clients hold and their current relative yields. These bonds are tied to infrastructure projects of various types from education (JEM Southbank) to airports (Sydney Airport), as well as defence (Praeco) and small projects like Southern Cross Station (Civic Nexus) and the Victorian County Court Facility (JEM CCV). Each of the infrastructure bonds listed below are senior secured, placing them at the top of each issuer’s capital structure. The key point is that they all have credit ratings better than the ASX hybrids of the major banks. Even at our base assumption of CPI at 2.5%pa (mid point of the RBA target range for inflation), the infrastructure bonds are at least comparable. If you use the current CPI of 3.0%pa, almost all of the infrastructure bonds are offering better yields than the lower rated hybrids.
One important feature of these infrastructure debt securities is that their rates are linked to inflation, ie if inflation rises, their rates will rise and equally if inflation falls, their rates will fall. This is similar, but not identical, to the floating rate nature of the hybrids – their rates rise and fall with interest rates, not inflation*. Over the longer term, rates and inflation are highly correlated, meaning both will offer a similar hedge against rising interest rates relative to fixed rate bonds.
*For the technically minded, the correlation between CPI and BBSW in Australia since 1982 has been 0.86, ie very high.
Prices are accurate as at 26 September 2014
The below table compares the Sydney Airport inflation linked senior bond against the NABPA hybrid.
** Yield for Floating Rate Notes is the swap rate to Maturity / Call plus the trading margin
** Yield for Inflation Linked Bonds and Index Annuity Bonds equals Real Yield plus a current inflation assumption of 3.00%
Prices are accurate as at 26 September 2014
FIIG’s view on “bail-in hybrids”
To be clear, we do not believe that there is a large risk of one of Australia’s major banks requiring a bail out. That is not the issue here. The issue is that these “bail-in hybrids” are new structures and the market hasn’t yet figured out how to price. This will make them more volatile. Investors should be getting paid for that volatility. And we don’t believe that they are. In Europe, investors demand around 5-6 times more margin for these hybrids than they need for senior debt. CBA’s recent Perls VII offer was at just 3 times CBA’s senior debt pricing.
In fact, we don’t even consider these securities to be bonds, but instead far more like equities. History has shown us that they won’t rise as much as shares in the good times, but will fall in line with equities in the bad times. Investors are getting the worst of both worlds, and are increasingly shifting their money to either pure bonds or equities instead.
The issue here is that the complexity of these hybrids is not yet understood and therefore not being priced in. But things are changing quickly. In the past few weeks, this debate has spread to Australia from Europe, where the regulators have banned distribution of these hybrids to retail investors. Many of the bail-in hybrids have fallen sharply in price since mid-August, with several now below their issue price (as shown below).
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