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Is ASIC right to slag hybrids?

In a week when ASIC suggested that the term ‘hybrid security’ should be replaced with the words ‘capital note’, regional banks Suncorp and Bendigo and Adelaide have announced new issues. These issues follow the very successful jumbo issue from CBA (PERLS VI), and will also qualify as Tier 1 capital for the banks under the new Basel III capital adequacy framework.

ASIC Commissioner John Price warned: “An expectation that at the end of a set period an issuer will definitely redeem the hybrid so that investors get repaid in full is very dangerous”. He is right of course – however, this just reiterates the importance of looking at the issuer and their underlying business, and the terms of the note. I can’t see what is wrong with the term “hybrid” – it implies exactly what it is, a security with both debt- and equity-like features.

The issues

Bendigo and Adelaide Bank is issuing $125m of convertible preference shares (CPS), which includes a re-investment offer to the holders of the existing Reset Preference Shares. These are being redeemed on 1 November.

Suncorp is issuing $350m of convertible preference shares (CPS2). Details of the issues, and a comparison with the recent CBA PERLS VI issue, is set out below.

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Institutional bookbuilds over the weekend will determine the final margins, which will be announced on Tuesday for Bendigo and Wednesday for Suncorp. With the 90-day bank bill around 3.39%, the grossed up distribution for the first quarter for Suncorp will be in the range of 8.04% per annum (pa) to 8.24% pa. For Bendigo, with the 180-day bank bill around 3.36%, the distribution for the first half-year will be in the range of 8.36% to 8.86%pa.

Dividends on these issues are fully franked. The cash dividend payment is adjusted for the franking credit benefit by multiplying the nominal distribution by 0.70. For example, if the final margin for Suncorp is set at 4.65%, and the 90-day bank bill rate is 3.39%, the dividend in cash for the first quarter will be (4.65% + 3.39%) x 0.70 = 5.628% pa.

Credit ratings

While the issues are not individually rated, the issuers (or their subsidiaries) are rated by Standard & Poors as follows:

Commonwealth Bank: AA-

Suncorp Group Subsidiaries: A+

Bendigo & Adelaide Bank: A-

Suncorp uses the ‘Non Operating Holding Company’ structure, and each of its three major operating subsidiaries is rated one notch lower than the CBA. Bendigo is a further two notches lower than Suncorp.

Pricing

The prospective margin reflects the financial institution’s credit strength, issue size, expected investor demand and alternative capital raising opportunities and costs. As I have said on many occasions, while an issue of hybrid securities to a retail market can be viewed as “opportunistic” behaviour by the issuer, that doesn’t mean the issue is underpriced.

The key risk investors face is that the issuer is not capable of (or not allowed by the Australian Prudential Regulation Authority (APRA) to redeem the security on the optional redemption date, or even worse, a ‘non-viability’ trigger event or ‘capital trigger event’ occurs. While Bendigo had a higher Level 2 Common Equity Tier 1 Capital Ratio of 8.09% than CBA’s 7.50%, Bendigo’s surplus capital above the 5.125% trigger is only $839 million compared to CBA’s circa $8.0 billion. Arguably, Bendigo is more exposed to a potential shock or single event risk.

While the Suncorp issue doesn’t have a capital trigger event, the Suncorp business includes banking and some of Australia’s leading insurance brands with names such as GIO, AAMI, Vero and Apia. This leaves it vulnerable to a catastrophic insurance event such as the Brisbane flood, and while it takes out re-insurance to minimise any impact, investors should be mindful of business risks such as these.

Overall

There has been some commentary that the margins might be a little skimpy. With the ‘headline margins’ and small issue sizes, we expect investor demand to be quite strong. At $125 million, the Bendigo issue looks too small for satisfactory post market liquidity. A measured investment in Suncorp as a “yield play” would suit many portfolios.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.