While we look at moving lower down the capital structure to improve returns for incremental risk, another benefit of investing in a subordinate position is the franking credits attached to the coupon payments of some over-the-counter (OTC) Tier 1 hybrids.
Some investors may rely on the franking credits received from share dividends for their personal tax situation, however OTC Tier 1 hybrids are another investment that pay franking credits. In this article, we discuss how the coupon distributions are typically paid on these fixed income instruments.
Background
Many investors would be familiar with franking credits attached to dividends paid by some of their equity holdings, but less so with their fixed income portfolio. However, some perpetual subordinated Tier 1 notes (hybrids), pay an income payment to bondholders comprising of a cash component and franking credits.
There can be tax benefits to receiving franked distributions depending on each investor’s circumstances. It’s recommended a tax advisor is consulted for further information.
In the following note, we discuss the coupon distribution on these instruments in more detail.
Coupon payments
Perpetual subordinated Tier 1 notes with franking credits attached, for the most part, are similar to any other fixed or floating note in the OTC market. Interest accrues according to the coupon rate, and an income distribution is made on each periodic payment date to note holders.
The only difference is the income received comprises a cash component and a franking credit component, which, in aggregate, equal the coupon rate. This means, the cash distribution is lower than what the coupon rate would otherwise imply, since the investor also receives franking credits. As such, the Tier 1 hybrid coupon rate is inclusive of franking credits. It should be noted that the structure for OTC Tier 1 hybrids is identical to ASX-listed hybrids that many investors would be familiar with (such as the Perls notes issued by CBA or the Capital Notes issued by ANZ, NAB or Westpac).
Franking credits are designed to reduce or eliminate double taxation, as the issuer has paid the corporate tax rate prior to investors receiving the distribution.
The franking credit component can change from each periodic coupon payment, depending on the amount of tax the issuer has paid on the distribution amount. Where there is a lower franked amount attached to the distribution component, then a larger cash component is paid to achieve the coupon rate.
The coupon statement, which is issued when a coupon payment is made, includes a split of the franking credit component, which is then submitted as part of the tax return for that financial year.
Case study
To demonstrate the cash and franking credit components of a distribution payment, we’ve used the NAB AUD perpetual subordinated Tier 1 2029c notes, paying a 4.95% coupon as an example. We have assumed the issuer (in this case NAB) has paid a fully franked payment on the distribution, as such, the maximum franked component is received as part of the coupon payment.
If a bondholder had a $50,000 face value holding of the NAB 2029c with a coupon rate of 4.95% (inclusive of 30% franking credits), it will receive a total value of $2,475 ($1,237.50 semi-annually) ($50,000 x 4.95%). From here, we’re able to calculate the cash and franking credit components.
The following formula, coupon rate x (1-30% tax rate), gives a breakdown of the cash return, while, coupon rate x (30% tax rate), provides the franked component. As a result, $1,732.50 is the cash payment (4.95% x (1-30%)), while the franked credit is $742.50 (4.95% x 30%).
This is for illustrative purposes only but provides an example of the coupon breakdown between cash and franking credits where the issuer has paid tax in full on the distribution prior. It is important to note that the actual value of the franking credits will depend on each investor’s circumstances and, as mentioned above, you should seek advice from a tax advisor to determine what benefit you would extract from the franking credits you are receiving.
The franking credit component on these instruments is only relevant when a coupon is paid, and not when they trade. As such, if bought or sold then the accrued interest paid to the seller is treated as per any other fixed or floating notes with no franking credit component. If traded in the ex-coupon period, then it is the holder of the notes on the record date who is entitled to the coupon, and this coupon has franking credits attached.
Conclusion
While many investors hold listed hybrids and equity holdings paying franking credits, the OTC perpetual subordinated Tier 1 notes also offer investors a return with franking credits attached. These instruments pay an income distribution on each periodic payment that includes a cash component and a franking credit component to bondholders. These franking credits can reduce an investor’s tax liability, depending on the individual circumstances.