I am a bit of a fan of the hybrid securities market, and while I thought it was getting a little top heavy (spreads too low), I didn’t quite foresee the change in market sentiment.
The latest hybrid issues have debuted at a material discount. Commonwealth’s jumbo PERLS VII (ASX Code CBAPD) issue, Macquarie’s Bank Capital Notes (MBLPA) and Challenger‘s Capital Notes (CGFPA) are each trading at a discount of around 2% to 3% of their issue price. This may not seem like a lot – however it is worth around 30 to 40 basis points – and this is material to a yield-focused investor.
Before I go into the reasons and discuss where this market may head, I want to make a disclosure about ‘vested interests’.
Every market has vested interests, however I think the hybrid securities market gets close to taking the cake.
Firstly, there are the issuers – the banks and the insurance companies. They have absolutely no reason to issue into this market except when it provides funds (or capital) at a lower all up cost than other markets. Their other alternatives are generally to wholesale investors and markets, whereas the listed hybrid securities market is largely retail and small institutions. So, they approach this market in a totally opportunistic basis. They issue when it suits them.
As a shareholder, I have no problem with this approach. As an investor, I am conscious that our interests are unlikely to be aligned.
Secondly, there are the brokers and financial planners. Many of these advisers are being paid a placement fee on investments you make in new issue hybrid securities. Typically a rate of 1%, if you invest $50,000, the broker or planner gets a “commission” of $500. This is all perfectly legal – and must be fully disclosed.
On the other hand, there are the interests that don’t like the ASX-listed markets because this reduces their opportunities to sell unlisted investments or funds.
Finally, there is the regulator – ASIC – which desperately wants to be seen as being relevant. ASIC has gone to great lengths to make sure that issuer PDSs carry risk warnings about hybrids being “complex products”, and encouraging investors to “test their understanding” at the moneysmart website.
Why the kick up in spreads?
While sometimes supply creates its own demand, this was a case of compressed spreads being met by three new issues in quick succession. To provide some context of how much spreads have come in, CBA’s PERLS VI issue, the first of the new style Basel III capital issues, was priced at a spread of 3.80% over the 90-day bank bill rate – the latest PERLS VII issued was priced at a margin of just 2.80%.
Then, Standard & Poor’s (S&P) announced a revision to its criteria for assessing the ratings of banks’ hybrid capital instruments. Effectively, this led to a one-notch downgrade for many hybrid issues. For example, Westpac’s equivalent Basel III capital issues, WBCPD and WBCPE, have been downgraded by one notch from BBB to BBB-. Although at the bottom of the investment scale, BBB- is still “investment grade”.
Interestingly, retail investors aren’t allowed to see security and issuer ratings when they invest, because for some incomprehensible reason, ASIC prohibits publication in the PDS. Wholesale investors get to see the ratings – the media can talk about them – and so a downgrade still has an impact. Further, it potentially makes alternative funding sources more expensive.
Adding to the negativity, there has been increasing speculation that ASIC may be pressured to follow the lead of the UK’s financial services watchdog, the Financial Conduct Authority or FCA. The FCA has placed a 12-month restriction on financial services firms distributing these new style hybrid securities that qualify as capital (called ‘’contingent convertibles” in the UK) to the mass retail market.
While the UK banks aren’t in as strong a shape as Australian banks and the ban doesn’t apply to high net worth investors (anyone with income over approximately $200,000 or investible assets of more than $500,000), where one regulator goes, others tend to follow.
Finally, yields on bank shares have increased as the market has fallen. At $81, CBA ordinary shares were prospectively yielding 5.2% – at $76, it is up to 5.5%. While this is not a direct comparison, as they are arguably quite different investments, there is always going to be some impact to the other if one investment becomes much cheaper.
Where to from here
My sense is that there is now a little bit of value to be found in some of these issues. The ANZ tier 1 capital issue from March this year, ANZPE, which pays a gross coupon of 3.25% over the 180-day bank bill rate (6.005% on its next payment date), was trading on Friday at a price of $98.00 – putting it on a spread of 3.57%. (gross yield of 6.95%).
Historically, major bank spreads around 3.5% looks about middle of the range. There are still investors searching for yield, and it is very unlikely that there are going to be any new issues in the short term. It’s too late to sell – use this market weakness as an opportunity to selectively add to your portfolio.
Important: 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. Consider the appropriateness of the information in regards to your circumstances.