As published in The Australian 24 May 2016 Last week, Westpac announced its latest hybrid offering
It hopes to raise $750 million. The first call or expected term is 5.5 years with mandatory conversion after 7.5 years, assuming all the conditions are met.
Interest will be between 4.9 and 5.1 per cent over the benchmark rate which is currently around 2 per cent, providing an all up distribution of about 7 per cent per annum, assuming you can claim franking.
This rate is slightly lower than the 5.2 per cent spread of the last hybrid issued by CBA in February. Since that time, margins or spreads on a range of bank securities have reduced, proportionally more than the hybrids, making the Westpac offer look fair.
A seven per cent return is a very attractive rate in a low interest rate environment and no doubt Westpac will raise far in excess of its stated $750 million target.
The interest rate will be a blessing to investors crying out for reasonable income when deposit rates are less than 3 per cent but to the more cautious investor it should ring alarm bells. At more than three times the benchmark rate and way above government bond rates, there are clearly a number of risks that need to be taken into account.
These instruments are much more like the underlying bank shares than the far safer term deposits. In fact they are issued to be “loss absorbing” in the worst case scenario. That is, they will lose value to ensure the ongoing survivability of the bank.
There are a number of other significant risks, so I would urge you to get hold of the prospectus and read it to make sure you know what you are investing in. You then need to determine if the returns on offer are enough to compensate for the risks.
Coincidently, this week I delivered a paper “Weighing up the value of hybrids” at the Australian Shareholder’s Association National Conference in Sydney.
I spoke for around 45 minutes on how you might assess the relative value of hybrids. Just looking at price and term to call isn’t enough. Here is a rough guide of what was covered.
- Compare the hybrid to those of the same bank already on issue. Are the terms and conditions the same? Are there any hybrids with similar terms to maturity? Is the yield to call lower, similar or better?
- Then compare to other similar structured hybrids from other banks again assessing the terms and conditions, yield and term to call.
- Sticking with the Australian market, have a look at securities that are slightly lower and higher risk. It’s a bit like shopping for a house – by looking at investments that sit outside your target you can better assess their value. In this case I would look at subordinated bonds (debt instruments) which have a defined maturity date and interest cannot be foregone. Then I’d have a look at the Westpac shares which are a bit more volatile than the hybrids but much simpler. While there is no certainty over the dividend and there is no maturity date you do have the opportunity to outperform if both to move higher.
Major bank subordinated bonds for similar terms earn roughly 4.3 per cent per annum, while the shares earn around 9 per cent including franking. Part of the benefit of these investments is that they are much simpler.
- To truly get a feel of relative value, you need to look at international hybrid markets. The European market has much greater depth with 47 banks issuing AUD145 billion equivalent in 98 hybrids. The Australian market is much smaller by comparison with 10 banks issuing 30 hybrids worth AUD30 billion.
It’s really important to understand the risks of these instruments and not over allocate to them assuming they are high paying deposits. I think it’s best to include them in your equity allocations as they do have franking credits.