Tuesday 07 June 2016 by FIIG Securities cane toad Opinion

Hybrids - the good, the bad and the ugly

Just as cane toads have evolved to survive in a range of climates, hybrids have evolved to adapt to changing regulatory and interest rate environments

Originally published in The Australian on 7 June 2016


The similarities do not end there because just like cane toads, hybrids have good, bad and ugly characteristics.

The good

Hybrid margins (the difference between the interest earned and the benchmark interest rate) are higher than what has been offered historically and are attractive, especially in a very low interest rate environment. Interest is calculated quarterly and all ASX listed bank hybrids are floating rate. Back when interest rates were high, hybrid margins were relatively skinny. NAB’s National Income Securities (ASX: NABHA) were issued in financial “pre Jurassic times” (1999) with a margin over the benchmark of just 1.25% pa and investors were happy to invest at that level.

Paying better – hybrid spreads widen

Source: Bond Adviser

In recent times, margins have increased. All of ANZ’s five listed hybrids were issued in the 3% range. But returns hit a low point in October 2014 with the CBA Perls VII issue offering a margin of just 2.8% over the benchmark. This issue was a big one with CBA raising $3 billion at a very good rate. Since then investors have sold down the hybrid and the price trades well below its $100 value and is often in the high $80s to low $90s, pushing the margin up for new investors to over 5%.

While CBA wins the prize for the lowest margin hybrid on issue its latest issue, Perls VIII issued in February this year, was at the other end of the scale with a 5.2% pa margin, perhaps rewarding tolerant investors for past mis pricing. This issue has tended to trade above par, implying investors would be satisfied with a lower rate.

The most recent Westpac issue, Capital Notes 4 (ASX: WBCPG), settled at a 4.9% margin and raised $1.45 billion, well over the targeted $750 million, a good result for investors and the bank. Next horse out of the gates was NAB, aiming to raise at least $750 million with a target margin of between 4.95 to 5.1%, a small sweetener over the Westpac issue. The book build is due by 7 June, with the final margin expected to be announced on 8 June.

Separately, ANZ has announced it intends to issue a USD hybrid, a first for any Australian bank. Considerable work would have gone into marketing the issue, but they will reap the benefits of expanding their investor base and having issuance in another currency. The cost of the issuance is rumoured to be higher once swapped back into Australian dollars at around 5.5% over the benchmark – a premium for a new market that is fairly typical.

Assuming the ANZ deal is successful, it will open another market for the majors and could mean reduced issuance here. Depending on demand, this could push hybrid prices higher. Conversely, the issue will provide an international comparison of margins and terms for our own insular, domestic market.

Ultimately I expect we will see a greater range of terms including write down and write back of capital and possibly higher triggers of 7%, as well as fixed rate issues, particularly as global benchmarks are at very low levels.

The bad

The outstanding issue is that the complexity and range of terms and conditions in hybrids makes them hard to assess. Comparing older hybrids that were more debt like with new ones is extremely difficult. For example the ANZPC and WBCPC were issued soon after Basel III was implemented and contain capital trigger clauses but not a non viability clause that was mandatory from early 2013. So what extra return do you require over and above the margins on those securities to compensate for the additional risk?

The ugly

The conversion terms and conditions especially those following a ‘loss absorption’ event are ugly. Practically every hybrid has variations to these terms and percentage conversion rates can differ, even if issued by the same bank – hybrids continue to evolve.  

Investors should be aware of multiple possible outcomes, and follow the share price of the bank as it determines conversion or not. For example the NABPD requires that “The VWAP of ordinary shares on 25th business day immediately preceding (but not including) a potential mandatory conversion date must be greater than 56% of the issue date VWAP”. All new hybrids have similar clauses. It means hybrids aren’t set and forget investments and that you need to keep track of share price movements. Those hybrids issued when share prices are high are at greater risk of non conversion. 

NABPD conversion conditions

Source: National Australia Bank, NABPD prospectus, page 24