Wednesday 30 January 2019 by Elizabeth Moran Opinion

Subordinated debt and hybrids square off

The Labor party proposal to remove franking credit refunds for investors that do not pay tax, will see asset classes compete on a more level playing field. Investors will need to reassess the risk and reward of various investments. Subordinated bonds become much more attractive on a relative basis
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Every company has a capital structure stack. It tells liquidators/ receivers how to apply the proceeds of asset sales in the event of wind-up or liquidation. Subordinated bonds sit above hybrids in the stack, see Figure 1. They are debt instruments with a known maturity date and interest payment dates, which gives investors more confidence.    

Hybrids are the next level down, so theoretically get repaid after subordinated debt holders in the event of a wind-up. While some of their characteristics are the same there are some important differences that make the hybrids much more complex for the unsuspecting retail investor.

Hybrid investors take on more risk than subordinated bond investors and so need to be appropriately rewarded – returns should be higher.

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Note - Subordinated debt category includes subordinated bonds.

At the moment, investors can claim franking credits on their hybrids, increasing the return and relative attractiveness compared to the lower risk subordinated bonds.

Let’s explore the two investments in more detail.

Common characteristics

The two investments have similarities and differences.
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Too often, unsuspecting retail investors compare major bank hybrids yields with deposits and for those that can claim franking credits, the pick up in yield of around 2.5%pa, almost doubles many deposit rates on offer. That’s very attractive.

But scratch the skin and understand what’s underneath before deciding between a hybrid and a subordinated bond.

How hybrids and subordinated bonds differ
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Yield comparison

If you cannot claim franking credits, then the yield differential between the subordinated bonds and the hybrids is marginal. So, illogical to invest in the higher risk product for no meaningful additional return. The subordinated bonds become the far superior option.

Another recent, important announcement by APRA should also be factored in when considering investing in either subordinated debt or hybrids. Late last year, APRA published a discussion paper proposing an increase to capital requirements for Australia’s four major banks. The proposed amount of $80bn, according to APRA is largely expected to be met by new subordinated bond issuance.

Significant additional supply, has a few consequences:

  1. All issuers would likely be forced to increase the yield or spread (margin above BBSW) offering more attractive rates to investors. This may be negative in the short term for existing holders, but the majors are regular issuers in international markets and its very unlikely all of the new required capital would be issued in the domestic market.
  2. Higher returns would further enhance subordinated debt attractiveness relative to hybrid yields if they failed to adjust accordingly.
  3. Hybrid investors are further subordinated in the capital structure. Except at the point of non viability when both subordinated bonds and hybrids convert to shares.

Sample subordinated bonds available

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For more information please call your local relationship manager or read the Factsheets