Wednesday 07 November 2018 by Asmita Kulkarni Education (advanced)

Hybrids – equity like risks, bond like returns

CBA announced a new hybrid last week. While the yield is attractive it’s worth noting hybrids are very complex securities and do not offer the same protection as bonds. Here we assess the differences

WireHybrid update image
Background

Last week, CBA announced it will be raising a minimum $750m through the issuance of a new hybrid security, PERLS XI (ASX: CBAPF). Similar to other bank issued hybrids, the PERLS XI notes represent a subordinated and unsecured exposure to CBA. Hybrids are issued by banks to meet their loss-absorbing Tier 1 capital requirements with APRA. 

The complexities of hybrids make these securities very different to bonds. ASIC classifies these securities as “complex investments” and notes hybrid securities may not be suitable for those needing “steady returns or capital security”. Please refer to the ASIC MoneySmart website for details. 

In 2016, APRA chairman, Wayne Byres, noted the following about investing in hybrid instruments “Viewing these capital instruments as simply higher-yielding substitutes for vanilla fixed interest investments, let alone deposits, is something to be counselled against, since from APRA's perspective holders of these instruments are providing the important first lines of defence that we can call into action, in some instances even ahead of shareholders, to aid an orderly resolution”.

With all this in mind, it is easy to see that hybrids expose investors to equity like risks at bond like returns. As such, the returns are disproportionate to the inherent risks.

The factors that make hybrids riskier than bonds include the ability for the issuer to not pay a coupon when due, ability for the securities to convert to shares and higher price volatility exhibited by hybrids. Below, we compare the key terms of the PERLS XI against a senior ranking CBA bond as well as a junior Tier 2 subordinated CBA bond and look at price performance of these securities.

Key Terms

Hybrids updated table

While at face value it appears that the PERLS XI pay a higher coupon than the CBA subordinated bonds, it is actually quite a cheap form of funding for the bank thanks to the current imputation credit framework in Australia. Should the Labor party win the next Federal election, based on its current proposals, the coupon of PERLS XI will reduce for those unable to claim franking credits. This means the proposed coupon on this hybrid of 3.70%-3.90% above BBSW will reduce to around 2.59%-2.73% above BBSW comparable to the lower risk investment grade rated Tier 2 sub debt. If you can’t claim franking, you are not being compensated for the risk.

The CBA bonds have set maturity dates when investors can expect to be repaid. So for every $100 of face value invested, $100 will be returned on the maturity date. Hybrids are perpetuities, meaning they can remain outstanding without investors receiving their initial capital back, though this is unlikely. 

CBA is issuing PERLS XI in order to redeem the existing PERLS VI securities, this is generally the method employed by banks in order to refinance hybrids at early redemption dates. Given there is no obligation for CBA to call the perpetual PERLS XI notes, any early redemption of these notes will likely be dependent on the prevalent market conditions in April 2024.

Most importantly, the PERLS XI have discretionary coupons, meaning CBA at its absolute discretion can choose not to pay any distribution on the hybrid. This non payment does not accrue nor does it qualify as an event of default. Additionally, coupon distributions can only be made as long as there is no objection from APRA and the regulator has the ability to halt all distributions on hybrids if the bank’s CET1 capital ratio falls below 8%. CBA’s CET1 ratio was 10.1% at 30 June 2018. 

In contrast, the coupons on the senior and subordinated bonds are mandatory and any non payment of coupon is considered to be a CBA event of default, which would accelerate payments on all outstanding CBA liabilities. 

Hybrid performance
The chart below compares performance of CBA issued securities during the GFC. It assumes $100 was invested in each of the three instruments – shares, hybrids and bonds, in November 2007 and takes into consideration dividends and franking on shares as well as the interest payments on bonds. 

The chart shows that hybrids do not offer investors any capital protection in times of stress.  During 2008-2009, when there was strong market uncertainty, hybrid prices were highly correlated with equity prices (red circle), and when markets settled down and equities rebounded, hybrid prices were correlated with bond prices (purple circle). 

While past performance is not indicative of future performance, assessing historic price behaviour provides a window to the future.  Based on the observations in the chart below we can see that hybrids behave like equities when times are tough (equity prices fall) and behave like bonds when times are good (equity prices rise). It also shows the inherent price volatility of hybrid securities compared to bonds. 

Wire 8 Nov Hybrids chart 2

Conclusion
Investing in hybrid securities is fine, but consider them to be more like equities and less like bonds. They will not protect your capital in the same way as bonds in a severe correction. 

The factors that make hybrids riskier than bonds include:
• The ability of the issuer not to pay a coupon when due
• To convert to equity to protect bond holders higher in the capital structure at the worst possible time
• Higher price volatility 

Hybrids expose investors to equity like risks at bond like returns, that is, the returns on hybrid securities are disproportionate to the inherent risks.

Please contact your FIIG Relationship Manager or myself at asmita.kulkarni@fiig.com.au if you wish to discuss the merits of various fixed income securities.

Links
ASIC MoneySmart – Hybrid securities and notes 
CBA bank hybrid securities basics

Links

ASIC MoneySmart – Hybrid securities and notes

CBA bank hybrid securities basics

Westpac guide to bank hybrids

 

Glossary

CET1 capital ratio: The Common Equity Tier 1 (CET1) ratio is a ratio of a bank’s total CET1 capital to its risk-weighted assets, where CET1 capital is the strongest form of capital held by a bank

Non Viability Trigger Event: A Non Viability Trigger Event occurs when APRA notifies CBA in writing that is believes:

  • Exchange of all or some PERLS XI is necessary because, without it, CBA would become non-viable; or
  • A public sector injection of capital is necessary because, without it, CBA would become non-viable

Capital Trigger Event: A Capital Trigger Event occurs when CBA or APRA determine that CBA’s CET1 ratio is equal to or less than 5.125%. If a Capital Trigger Event occurs, CBA must immediately exchange all or part of PERLS XI to common shares to return the CET1 capital ratio above 5.125%.

The diagram below looks at CBA’s loss absorption capacity and AT1 distribution ability

hybridglossary

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