Monday 19 March 2018 by FIIG Securities falling Opinion

Hybrids will need a rethink under Labor’s latest policy

Labor's Batman by-election win in Victoria makes its proposed changes to franking rules more promising. It's a good time to reassess your investment decisions and potential loss of income, especially if you are invested in hybrids. These securities are expected to be less attractive and prices to be more volatile

​As published in The Australian on 17 March 2018.

Once again retirees will need to rethink their investment strategies if Labor’s latest proposed policy to remove cash refunds on franking credits is passed, assuming they win government. With Labor in front in the polls, any investor potentially affected should be assessing the loss of income and how the proposed change might affect their investments – especially very popular bank hybrids.

It’s unfair and getting harder and harder for retirees to live off savings when the rules keep changing. Perhaps the underlying message from both parties is to keep on working for longer.

From my perspective, and that of a ‘best practice’ approach to portfolio allocation, the move is welcome as it begins to remove biases in favour of higher risk asset classes. The franking credit distortion increases the attractiveness of higher risk hybrids and shares, resulting in too many Australian retirees over-exposed to risky assets, with percentages far exceeding allocations in most other developed countries.

Franking credits also make it difficult to model fair value and forward prices, as the value of the tax credit the franking generates is dependent upon your tax rate within your investment entity.

Obviously, as most readers would know, franking is most beneficial to tax-free pensioners as they get a cash rebate rather than a deduction. At least that has been the arrangement for almost two decades now.

Calculating the impact

Those that had invested in hybrids for franking credit refunds now need to review their investments.

If we use Westpac’s latest hybrid, the WBCPH issued last month as an example, the stated return, assuming you could claim franking, was the benchmark 3 month BBSW plus 3.20 per cent per annum, equating to just under 5 per cent per annum. The thing you must note with hybrids is that they assume all investors can claim franking and so the stated return already includes it.

If you have a look at page 19 of the WBCPH prospectus, it shows the distribution rate without the franking to be just 3.2 per cent per annum. On a $100,000 investment, the proposed change would see income of $5,000 decline by $1,500 to around $3,500.

There is no doubt that if the capacity to claim franking is entirely lost then the hybrid return is far too low for the risk involved. If we look at other investments in a bank’s capital structure starting from least risk and increasing, investment in the hybrid could not be justified on a relative risk and return basis.

Very low risk, government guaranteed term deposits from a major bank are paying about 2.4 per cent per annum, while a subordinated major bank bond, still two notches higher in the credit rating assessment and substantially lower risk than the hybrid, pays 3.12 per cent per annum until its first call in 2021. The subordinated bond has a firm final maturity date and interest cannot be foregone.

This particular bond also has a shorter term to expected maturity of less than half the term of the new hybrid. Yet if you discount the franking on the WBCPH, the hybrid shows a small 0.38 per cent premium – simply insufficient for the risk and return dynamics between the two.

Moving to the other side of the risk divide, dividends on bank shares are between 5.6 and 6.6 per cent per annum, without franking.

So, without franking, hybrid returns are closer to those of corporate bonds but, as I mentioned in my column, last week, are complex and much more like the shares. Hybrid returns need to be closer to the share return to be justified.

Investors need to ask four questions:

  • What is my potential loss of income if the policy is passed in parliament?
  • How would this impact my lifestyle?
  • Do I accept a lower return for hybrids?
  • Do I sell down part, or all of my hybrid portfolio now or adopt a wait and see approach?

A changing hybrid market  

Overall then, depending on the numbers of investors impacted and their investment decisions, I would expect existing hybrids to become less attractive, and prices become more volatile as they have in the last few days.  The banks may need to rethink the returns on offer as well as how they are shown, so investors can better understand them.

Without knowing the numbers of investors affected by the legislation and which hybrids they may own, it is difficult to judge the volumes that may be sold and the impact on hybrid prices.

You certainly don’t want to be heading for the door at the same time as other investors as prices will fall meaningfully.

Lower risk bonds and ordinary bank shares should both benefit if the legislation passes.