The Goodman Group announced an offer to exchange its hybrid last week for a new equity-like hybrid security, disappointing those investors who were expecting them to call it in May next year
This is controversial decision by Goodman as many hybrid investors rely on the threat to reputation combined with the ongoing need to access debt capital markets to provide comfort that rated issuers will exercise their option to redeem securities at call dates. This note explains the types of calls available in the market and the incentives of calling or deciding to defer for the issuers.
There is often confusion amongst investors as to whether an issuer will call their bonds or hybrids early and repay the principal prior to maturity. Much of the uncertainty arises from the variety of call structures particularly in hybrids. The different call features along with the prevailing market conditions for replacement capital provide issuers with incentives (or disincentives) to exercise their calls. The following is a general guide to assist in understanding the callability of bonds.
There are two types of calls:
- Issuer call - this is a common feature of many bonds and hybrids and provides the issuer with an early redemption option. This allows the issuer to elect to repay the bond or hybrid principal on a defined date(s) prior to the maturity date.
- Investor call - less common than the issuer call, this is an option for the investor to require the issuer to repay the principal prior to the maturity date. A variation exists in hybrids where the investor can require conversion into ordinary equity that the investor must then sell on market to receive principal return of the funds they originally invested.
Senior bonds - these bonds have fixed maturity dates and the vast majority do not have call dates. Generally, there is no option for the issuer or investor to call these bonds and repay the principal early. Notable exceptions are equity linked or convertible bonds - these are bonds that can be converted into ordinary shares in defined circumstances.
Subordinated bonds - subordinated bonds frequently have a call date as well as a maturity date. The call date is usually at the option of the issuer, and when the issuer exercises this option the investor is repaid the principal amount at the call date. If the issuer does not call the bonds there is often a change in the interest payments from fixed to floating rate which may be accompanied by a step-up in the interest rate.
Banks and insurers have traditionally issued these bonds as they can qualify for regulatory capital (known as Tier 2 capital) and as they require ongoing access to the global debt markets it would be very damaging for an issuer's reputation to not exercise their call options. No major Australian issuer has failed to exercise their call option.
The revised global prudential regulations (Basel III) that are being implemented by the Australian regulator (APRA) in 2013 are likely to see a reduction in the volumes of Tier 2 capital for Australian banks as the new requirements do not allow for any step-ups and include loss absorbency features for Tier 2 capital where the bonds can be converted into ordinary shares or written off where APRA determines the bank has become non-viable. This increases the equity-like nature of these securities and decreases their differentiation from Tier 1 capital in terms of risk and return. These regulatory changes increase the likelihood of existing bonds that will be non-compliant with the new rules being called by issuers on the first call date.
For example, the insurer Suncorp Metway issued A$135m of fixed rate bonds at 6.75% in September 2004 (equivalent to swap + 1.00%) that mature in 2024 with an issuer call option in September 2014. The structure of this bond is a 20nc10, this refers to its 20-year term with an issuer call right at 10 years. If Suncorp Metway does not call these bonds at 10 years then the interest becomes floating rate and increases by 1.00% (3m BBSW + 2.00%). The insurer then has ongoing quarterly call options at coupon payment dates.
International Tier 1 (also known as hybrids) - these are generally trust preferred securities that are perpetual with a defined non-call period, between 5 and 10 years. They are often floating rate securities that have a step-up in interest rate after the call period. These structures are likely to change in 2013 when the revised global prudential regulations (Basel III) are adopted. This will have the likely impact of pre-Basel III Tier 1 securities that have a step-up being redeemed at their first call date as their contribution to regulatory capital will be zero from 2013 once they have passed their first call date. Transitional rules will apply to other existing securities with a phase out in the regulatory value (a 10% haircut for each year starting in 2013) further incentivising issuer's to call their securities.
An example is the Rabobank floating rate (3m BBSW+ 0.67%) trust preferred security issued in 2004. This security has an issuer call in 2014 (10 years) when the interest rate will increase to 3m BBSW + 1.67% (1.00% step-up). In FIIG's view, these securities are very likely to be called at the first issuer calling in 2014 as they contain a 1.00% step-up in interest rate making them ineligible as Tier 1 regulatory capital after that date.
Hybrids - these securities come in a variety of different forms that depend broadly on the market where they are issued (Australian or global), the type of issuer (corporate or financial institutions with associated prudential requirements), and the targeted investors (retail or institutional). Hybrids are also known as Tier 1 securities as they are generally eligible as regulatory Tier 1 capital for banks and insurance companies. In Australia those listed on the ASX are often called hybrids whereas those that trade in the unlisted/over the counter market tend to be referred to as Tier 1 securities. This is despite them having very similar structural features making Tier 1 securities and hybrids for all intents and purposes the same thing.
Each hybrid is different and investors should individually analyse the terms, however, the following are some generic types that are issued in the Australian market with issuer calls embedded in the structures (note investor call rights are unusual):
- Income Notes and Securities (perpetual floating rate notes) - these securities have no step-up and despite the existence of an issuer call option, were not sold with the intention of being called unless they could be replaced with cheaper funding. They also have no maturity date and are technically perpetual. These were the first generation of hybrids and there are unlikely to be any new issues due to the capital losses experienced by investors. An example is the National Australia Bank Income Securities (NABHA)
- Step-Up Securities - these securities are technically perpetual and generally have an issuer call option at five years. At the first call date the interest rate will step-up, typically by 1.00% to 2.00%, and the issuer can elect to call and redeem the securities or leave on issue at the new stepped-up interest rate. Post GFC/Basel III these have been mainly issued by corporations and an example is Woolworths who issued the floating rate Income Securities in 2006 (WOWHB) with a 5-year call option. In 2011, Woolworths exercised their issuer call when the margin was due to be stepped-up by 2.00%. There are also a number of "old-style" bank and insurance step-up securities such as the Perls III (PCAPA) and Westpac Trusts (WCTPA).
- Reset Securities - these securities are technically perpetual and typically have a fixed coupon for a defined term, normally five years. At the end of the five year period, the securities are remarketed where they can be redeemed, converted or a new fixed coupon rate is set (each security differs). These decisions can be at both the investor and issuer's election (or a combination of the two). An example is the IAG reset preference shares (IAGPA) that were issued in 2002 with a 5.8% fully franked dividend and a 5-year reset date. At the 5-year reset date, IAG reset the dividend to 5.63% for a further five years and investors could elect to convert the securities into common stock if they no longer wanted to hold the IAGPAs. On the last reset date in June 2012, IAG offered investors an exchange into a new security that is a mandatory converting preference share (IAGPC). The IAGPC has a franked dividend payment of BBSW + 4.00%. Where holders did not elect to exchange their IAGPA's they were redeemed at face value by IAG - 65% out of the $350m of IAGPA holders elected to be redeemed.
- Converting Securities - generally these are preference shares issued by banks and insurers for regulatory capital that mandatorily convert into the issuer's ordinary shares after a defined period of time assuming certain conditions occur. Traditionally converting preference shares offered the option for the issuer to redeem them for cash (via a third party), however, changing prudential requirements require replacement capital increasing the likelihood of equity conversion if market conditions are difficult. APRA has outlined new requirements under Basel III that include a regulatory capital trigger event where the bank's capital requirements are not met. In this instance, the securities will convert into ordinary shares with a cap on the number of shares an investor receives. The intent is for the investor to absorb some of the losses (ie lose capital) when the financial institution is in distress. This makes the latest round (and future) issues of bank hybrids more and more equity like. An example is the ANZ convertible preference shares (ANZPC) issued in 2011 with a franked floating rate dividend of 6m BBSW + 3.10%. These will mandatorily convert into shares in 2019 (8 years), however, ANZ has options to redeem and/or convert from 2017 if they replace the capital with APRA's approval. If ANZ's common equity capital ratio fails to meet APRA's required minimum of 5.125% then the ANZPC's will convert into ordinary shares with a maximum number of shares of 10.2407. If the ANZ share price is below $9.86 then the ANZPC investor will receive less than $100 of shares. In the event of the forced conversion it is likely that ANZ is in financial difficulty and the share price will be much lower than the $9.
When will an issuer choose to call a bond/ hybrid?
In making their decision whether to exercise the call option, the issuer will consider the cost of replacement capital, market reputation and the regulatory environment at the call date.
- Cost to reissue - the issuer will examine the cost to reissue their debt at the call date versus keeping the debt outstanding. This will depend on any step-ups in the existing security and credit markets at the time of call
- Access to market - in the professional investor markets there is often an expectation that issuers will exercise their call option at the first available date. This applies to the subordinated bond and international Tier 1 markets. When an issuer's bonds are initially sold to investors it is based on pricing the credit risk to the call date so any extension beyond this date means investors have not received adequate compensation (in the form of coupons) for the increased term. As the issuers of these securities are typically banks and insurers and require ongoing access to the global debt markets it would be very damaging for an issuer's reputation to not exercise their call option. An example of this is Deutsche Bank who did not call one of their bonds during the global financial crisis and found it difficult and more expensive to issue new bonds when they returned to the market. This reputational risk is not as prevalent in the retail hybrid market nor the corporate market where the companies are less reliant on ongoing access to debt markets.
- Rollover or exchange for a new security - this is another option for issuers and one that we have witnessed in Europe to the detriment of investors. Distressed European banks have called or exchanged the securities at the prevailing market value resulting in investors crystallising losses. In institutional markets this damages an issuer's reputation as the exchange favours the issuer and is often referred to as a coercive exchange. In Australia, Goodman's have used this option (explained in greater detail at the end of the article) despite continuing to be rated and this precedence is not one that we would like to see become commonplace in the hybrid market.
- Regulatory environment - there can be changes to prudential requirements for banks and insurers that alter the classification of the security as regulatory capital that may require the issuer to exercise their call option. For example, from 2013 Basel III will establish that step-ups in Tier 1 (hybrids) and Tier 2 (subordinated debt) will make a security ineligible as regulatory capital once it passes its first call date and accordingly, we expect banks to call their existing securities with this feature at the first call date. Accounting and tax treatment of the security may also influence an issuer's decision to call securities.
As you can see, call structures and the likelihood of the call being exercised differ across securities and issuers and it is important to consider the evolution of debt markets, particularly for subordinated and hybrid securities. We can say that issuers who need ongoing access debt markets will call their securities at the first available call date and this has been the historical experience of banks and insurers. However, regulatory requirements are changing with the implementation of Basel III in 2013 and the ability of issuers to call bonds will depend on the regulator providing approval and this may not always be granted. In times of distress, APRA may require the banks to leave the securities on issue or in cases of extreme distress, force conversion into ordinary shares where investors may face substantial capital losses.
The nature of the securities being issued is changing with the new generation of hybrids and subdebt being increasingly equity-like. At FIIG, we don't believe investors are being paid high enough coupons to take these risks and we continue to favor existing securities with older structures that are more debt-like and accordingly provide investors with much better protection. We also believe these securities have a high likelihood of issuer call on the first call date. See our recent recommendations on Swiss Re A$ FRN hybrid paying 11%, Rabobank Tier 1 securities and our list of other more debt like hybrids.
For further information on the new Basel III regulations please see our series on APRA's new regulations.
The issuer rollover or exchange offer - Goodman's example
Goodman's has recently highlighted another outcome that investors may be presented with on the call date - an exchange or rollover into a new hybrid security. Goodman announced a proposal for their investors to exchange their Goodman PLUS securities (GMPPA) for new terms, with the security to be called PLUS II. If holders elect not to approve the changes they will continue to own the GMPPA. The rollover provides holders with little choice other than to accept the new terms. The margin on the new hybrid at BBSW + 3.90% is below the level where Goodman's would be able to access new capital if they had to find new investors rather than rolling-over the existing GMPPA holders.
GMPPA holders' options are outlined below. Holders can either:
- Keep their existing GMPPA. The interest rate will step-up to BBSW + 2.9% on the 21 March 2013. This is too low a credit spread for the GMPPA. The GMPPA become a perpetual security that has stepped-up and has non-cumulative discretionary distributions. Based on an estimated 10% required running yield, this is where the other perpetual stepped-up securities trade and not necessarily what the yield should be, the price would move to around $65 from the current $90, or
- Accept the offer to exchange to the PLUS II. The new security will have a coupon of BBSW + 3.9% and a final maturity in 2073. The PLUS II will have a series of small step-ups starting in 10 years time (0.25% in 2022 and a further 0.75% in 2038). Due to the small size of the step-ups, these provide limited incentive for Goodman to redeem on those dates. Or in other words, investors may hold the PLUS II for a long time and should not be expecting a call in 10 years. Goodman's decision will be influenced by the ability to refinance at the call dates.
In either case, investors have no right to request redemption. GMPPA investors are being rolled into a long dated equity-like hybrid that has a final maturity in 61 years and no investor redemption rights. This feels a like a coercive exchange for investors. Goodman's has only provided a summary of the terms so we will have to wait for the full document to read the fine print.
Goodman's provides an example of a rated issuer whose credit has deteriorated since issue and at the first call date has elected not to redeem but to roll investors into a new security. Investors relying on the threat to Goodman's reputation will be disappointed by the company's decision not to call the GMPPA (and this provides an important indication of how issuer's view the retail hybrid market). In Goodman's defense they will argue that the PLUS II is a better outcome for investors and while this is true versus being left in the stepped-up GMPPA this is a worse outcome than being redeemed for $100. The current raft of hybrid issuers may consider similar options at their call dates in 5-6 years time if their businesses deteriorate. The rollover provides the issuer a way to optically protect their reputation (as they can argue they have offered a replacement security) but a suboptimal outcome for investors.
All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.