Tuesday 25 July 2017 by FIIG Securities beast Opinion

Bank hybrids are no term deposits – they are complex beasts and carry risks

As published in The Australian on 22 July 2017

Hybrids are complex. It’s important to understand the risks they carry and not over allocate to them assuming they are high paying term deposits

Term deposits are easy to understand. Hybrids are not.

Earlier this week, outgoing Australian Securities & Investment chairman Greg Medcraft stated that they were a “ridiculous” product for retail investors. He noted that they had been banned for retail investors in other markets such as Britain.

Yet they’ve been a consistent earner for retirees looking for income for years. No wonder it is difficult to marry the risk and reward when they have performed according to expectations. In that way, it’s easy to be complacent.

The hybrid market is fine, until it’s not — they are liquid until there’s another major stress event and then they are not. Returns are sufficient at around 5.5 per cent per annum until the risk is repriced, for whatever reason and then they’re not.

The reality is there’s a chasm between deposits and hybrids in term of complexity, risk and return.

That’s the crux of the matter. Medcraft realises that despite his warnings and excellent explanations of risk in prospectuses, few hybrid investors understand the risks well enough to qualify them.

As a starting point, deposits are Australian federal government guaranteed for up to $250,000 per entity per financial institution. So no matter what happens to a bank, deposit funds are government guaranteed to specific limits.

Hybrids do not have a government guarantee. They’re issued at the directive of financial institution regulator, APRA, which requires banks to hold capital for unexpected events. The hybrids are there as a back up if a financial institution gets into difficulty. They are deemed “loss absorbing capital” and issued to help the bank survive if it gets into trouble. Effectively, hybrids can have the same downside as shares: if the bank gets into trouble, shareholders and hybrid investors could lose the lot.

This was demonstrated last month when Spanish bank, Banco Popular Espanol was deemed non viable by the Spanish regulator. Shareholders and hybrid investors lost everything when they were “bailed-in”, in order to protect the bank’s survivability.

In contrast, the most senior bond holders and deposit investors did not lose any funds. Investors should be prepared to lose funds if the bank gets into difficulty. There is a much higher risk of loss compared to deposits in the worst case scenario. Hybrids have all the downside risk of shares. But unlike shares, the upside is limited.

The best-case scenario is that you are paid all of the distributions, remembering these can be forgone and never have to be made up, and conversion or repayment happens at first call. There is little upside potential in terms of higher hybrid prices, no matter what the growth of the institution. Here are some hybrid features compared to term deposits to note:

  1. Over the life of the hybrid, investors should expect price volatility.
  2. In the case of a stressed event, investors may find it hard to exit if they need the cash.
  3. There is a chance that the hybrid is not called at the first opportunity and becomes perpetual with no maturity date, which is unlikely but remains a possibility, with Basel III compliant hybrid prospectuses clearly stating securities are perpetual.
  4. The hybrid distribution can be deferred and is non-cumulative, whereas the interest payments on deposits cannot be deferred. Generally, hybrid prospectuses contain a “dividend stopper” clause providing some protection that, if hybrid distributions are forgone, the bank cannot make dividend payments on its shares, a big disincentive.
  5. Hybrids can be converted to shares if the bank breaches a minimum capital trigger of 5.125 per cent or APRA deems it “nonviable”. This is very unlikely. Further, as capital levels approach the trigger, APRA would step in and restrict hybrid distributions and this is a little more likely.
  6. The hybrid is closer in risk to the shares as it can forgo distributions and may never be repaid — the franking credits reiterate the relationship. Hybrids certainly deserve consideration as part of a balanced portfolio. But I’d caution against counting on them to perform in stressed markets. 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. 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 NAB Capital Notes 2 (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 per cent of the issue date VWAP”. All new hybrids have similar clauses. It means hybrids aren’t set and forget investments. You need to keep track of price movements.

Hybrids are complex beasts. It’s important to understand the risks they carry and not over-allocate to them assuming they are high-paying term deposits.