Lendlease recently issued a new fully franked Subordinated Hybrid, which garnered much attention for its higher grossed up yield and fully franked distribution. There are a handful of existing bonds in the Over-the-Counter (OTC) market that have franking credits attached to the coupon payments. In this article we discuss how the coupon distributions are typically paid on these fixed income instruments.
Background
Lendlease’s recent new perpetual non-call 3-year Subordinated Hybrid issue received a lot of attention for its fully franked distribution, which the coupon, made up of a cash component and franking credits, was very attractive for its risk reward profile at 7.4285%. 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, perpetual Subordinated Hybrids, pay an income payment to noteholders comprising of a cash component and franking credits.
There can be tax benefits to receiving franked distributions depending on each noteholders’ circumstances. It’s recommended a tax advisor is consulted for further information.
These fully franked OTC Subordinated Hybrids are also an alternative replacement for the ASX-listed bank hybrids that are being phased out by the regulator.
In the following note, we discuss the coupon distribution on these instruments in more detail.
Coupon payments
Perpetual Subordinated Hybrids 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 Subordinated Hybrid coupon rate is inclusive of franking credits. For example, the recent Lendlease issue is made up of a 5.20% cash component, and the grossed-up fully franked coupon rate is 7.4285%.
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. When the distribution payment falls due, the issuer advises of the percentage that is franked, be it 100% or a lower portion. Where there is a lower franked amount attached to the distribution component, then typically a larger cash component is paid to achieve the coupon rate (although the issuing documentation for each bond determines how the franked distribution is handled and in some instances where the payment is only partially franked, the issuer does not ‘top-up’ the cash component to reach the higher grossed up rate and the noteholder forgoes this portion).
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. Also noting to receive franked credits, noteholders must hold the Subordinated Hybrid ‘at risk’ for at least 45 days to be entitled to claim the franking credits as a tax offset/refund. This rule also applies to equity holdings also.
Case study
To demonstrate the cash and franking credit components of a distribution payment, we’ve used the new Lendlease AUD perpetual non-call 3-year subordinated Tier 1 2028c notes, paying a 7.4285% coupon as an example. We have assumed the issuer (in this case Lendlease) 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 Lendlease 2028c with a coupon rate of 7.4285% (inclusive of 30% franking credits), it will receive a total value of $3,714.25 ($1,857.125 semi-annually) ($50,000 x 7.4285%). 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, $2,599.975 is the cash payment (7.4285% x (1-30%)), while the franked credit is $1,114.275 (7.4285% 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
With the regulator phasing out ASX-listed bank hybrids, the OTC Subordinated Hybrids are an alternative option for their attractive returns and franked distribution payments. 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.