Tuesday 07 March 2017 by FIIG Securities CBAatm Opinion

Hybrids are back, so weigh the risk

As published in The Australian on 7 March 2017

After what seems like a break, the popular hybrid note market is back in action – shop around to get the best returns and note the dangers

After what seems like a break, the popular hybrid note market is back in action.

Once again investors desperately seeking income appear to be prepared to take whatever interest rate is on offer no matter the risk involved, as shown by CBA’s last three hybrids, the CBAPD, CBAPE and its latest, the CBAPF also known as Perls IX.

Reflecting prevailing markets conditions at the time of the issue, margins offered over the benchmark BBSW varied wildly, from 2.8 percent per annum for the CBAPD, 5.2 percent for the CBAPE to 3.9 percent for the CBAPF. Setting the price is a mix of interpreting the margins being paid in the Australian credit markets as well as overseas markets and weighing risk and other costs of issuing debt and equity.

CBA hybrids Margin (%)
Perls VII 2.80
Perls VIII 5.20
Perls IX 3.90

Source: FIIG Securities

In reality, banks looking to raise funds shop around, just like you would if you were looking to take out a new home loan. They want the lowest rates possible to reduce costs and increase profits and dividends.

CBA, as the nation’s biggest bank, can move the market. It’s a surprise then that the rate it offered for its latest deal the Perls IX (ASX: CBAPF), was slightly higher than existing comparable hybrids, making it more attractive to investors. But, after the disastrous CBAPD issue, with the tightest margin of any of the new style Basel III hybrids and the negative press, CBA would have been keen not to re-offend.               

Recent negative press regarding failure to payout trauma victims and a Deloitte report released yesterday by the bank into CommInsure's claims handling practices, may have contributed to the better than expected margin.

The Perls IX was successful in raising $1.45 billion, well over its $750 million target.

Challenger are the next to issue and hope to raise $350 million at a bookbuild margin between 4.4 percent and 4.6 percent with six years to optional exchange in May 2023. This is a decent uplift from a conservative institution and should see it easily reach its target.

While assessing how the prices are set is interesting, what matters is whether the reward is appropriate for the risk involved.

One way to try and work out if the reward is appropriate for the risk is to look at the additional risk and reward over the lower risk subordinated notes the NAB recently announced. The range they quoted for the notes is 2.20 to 2.30 percent per annum over the benchmark.

Bonds versus hybrids First call Final maturity Margin/ range (%)
NAB subordinated notes (bond) September 2023 September 2028 2.20 to 2.30
CBA Perls IX (hybrid) March 2022 Perpetual 3.90
Challenger (hybrid) May 2023 Perpetual 4.40 to 4.60
Source: FIIG Securities

Like the CBA hybrid, the NAB notes were also offered at a premium, making both attractive to investors.

CBA offered an extra 1.7 percent per annum over the NAB note for the additional risk. Is it enough?

Both returns are floating rate.

The excess spread offered by the hybrid over the NAB subordinated note compensates for the following:

  1. The hybrid is higher risk, hybrid investors would lose capital before bond holders, so over the life of the hybrid, investors should expect greater price volatility compared to the bond.
  2. In case of a stressed event, hybrid investors may find it hard to exit if they need the cash. The bond may also be harder to sell but the known maturity date adds comfort.
  3. There is a chance that the CBA hybrid is not called at the first opportunity in March 2022 and becomes perpetual with no maturity date, which I consider unlikely but remains a possibility with the prospectus clearly stating the securities are perpetual. The NAB note also has a call date in September 2023 but does have a final maturity date five years later in September 2028, when NAB is bound to repay the note.
  4. The hybrid distribution can be deferred and is non-cumulative, whereas the interest payments on the bonds are legal obligations and cannot be deferred. While the risk of CBA reducing or not paying distributions may be considered low, it should be factored in when assessing risk.
  5. Both the hybrid and the bond can be converted to shares if APRA deem either bank “non-viable”. This is very unlikely. So too is the possibility that CBA breaches its minimum 5.125 percent capital requirement and the hybrids convert to shares, but the risk exists and as investors you should be compensated for it. As capital levels approach the trigger, APRA would step in and restrict distributions on the hybrid, and this is perhaps a little more likely.

The hybrid is closer in risk to the shares, it can forgo distributions and may never be repaid – the franking credits reiterate the relationship. It takes on all the downside risk of the shares but enjoys none of the possible ‘blue sky’ upside. The hybrid is far more complex and I think the complexity in its own right deserves extra compensation.

I’m a risk averse investor, so have a natural tendency to prefer the lower risk NAB note. I wouldn’t invest in the new CBA hybrid, as I think there’s enough evidence that the banks need to raise more capital – so expect further issues to come to the market which, as has just been demonstrated by Challenger, could be at a premium to the prevailing CBA rate.

I know there are some avid hybrid investors in the market and hybrids certainly deserve consideration as part of a balanced portfolio but would caution against counting on them to perform in stressed markets, as they do not offer the same defensive characteristics that you can find in bonds.

One thing is for sure, the banks still need to raise further capital so in the highly unlikely event that you miss out on an allocation to either of these investments, there's likely to be plenty more just around the corner.