Why I like NAB’s new hybrid issue

Co-founder of the Switzer Report
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News that one of Australia’s largest super funds, Q Super, was going to bid for $200m of NAB’s new ASX-listed hybrid security has fueled demand for the issue. On Friday, NAB announced that it would issue at least $1.65bn of NAB Capital Notes 3, up from an original $750m.

Typically, the domain of retail investors, the strong support for this hybrid by institutional investors means that the fixed margin of 4% is seen as attractive and that the issue will be keenly supported. By historic standards, this is about  “middle of the range” for ASX retail hybrid issues. CBA, which has been the most prolific issuer, has launched its capital notes issues (PERLS) in recent years from a high margin of 5.2% to a low margin of 2.8% (see table below).

Notwithstanding that ratings agency Fitch also announced on Friday a downgrade in NAB’s long-term credit rating outlook from Stable to Negative, there isn’t that much difference between the two banks.

While “4%” looks about the mark, there are still two negatives for the hybrid securities market. Firstly, the margin between bank ordinary share dividend yields and hybrid security yields is high by historic standards. Were it to close to a more normal level, this could be achieved by a rally in ordinary share prices, a fall in hybrid security prices (and an effective increase in the margin), or a combination of the two.

The other negative is the impact of the ALP’s proposed change to stop the refunding in cash of excess franking credits. Hybrid security dividends are typically fully franked, and as these securities are the domain of retail investors and SMSFs, they are very exposed to this change. After listed investment companies trading at a premium, they’re probably the next most exposed sector.

Some say that the impact of the change is already “priced in”, pointing to the rise in hybrid margins in 2018. An alternative scenario is that the rise in hybrid margins occurred as the yields on bank ordinary shares were also rising.

I have argued that if the ALP wins government, its franking credit change will be watered down by a populist Senate cross-bench and hence I don’t see the change as such a big negative. However, that doesn’t mean that the market won’t get a couple of wobbles should the ALP win in May.

Putting this all together, I like the issue and the margin and will be investing. But I will also be keeping some powder dry for the next issue and any weakness in the secondary market.

Here are the details of the issue. Because these are complex securities, please don’t consider investing unless you have a good handle on how they work and the risks. In addition to the information below, ASIC’s Money Smart website has a useful guide at https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes

NAB Capital Notes 3

NAB Capital Notes 3 will pay a quarterly, fully franked distribution. This is calculated at a fixed margin of 4% over the then 90-day bank bill rate, and then adjusted by the company tax rate (to take into account the benefit of the franking credits). The distribution is re-calculated each quarter.

With the 90-day bank bill rate currently around 2%, this implies a gross distribution rate of 6% pa for the first 3 months (2% plus 4%). The actual distribution in cash, which is fully franked, would then be 4.2% (6% x 0.70 = 4.2%).

Distributions are discretionary and subject to payment conditions. If a distribution is not paid, it doesn’t accrue and won’t subsequently be paid. To protect holders from this discretion being mis-applied, National Australia Bank is then restricted from paying a dividend on its ordinary shares.

Conversion into NAB shares or Early Repayment

NAB Capital Notes 3 are perpetual and have no term. However, NAB must (subject to a test) convert the Notes into NAB ordinary shares on 19 June 2028 (in about 9.25 years’ time). If conversion occurs, holders are issued $101 of NAB ordinary shares for every Capital Note of $100 face value (which effectively means that they’re issued NAB shares at a 1% discount to the then market price). The test for the conversion is the market price of NAB ordinary shares at the time – provided they are higher than approximately $12.23, conversion occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.

To qualify as regulatory capital for NAB, two further events cause mandatory conversion – a ‘common equity trigger event’ and a ‘non-viability trigger event’. Under these tests, the Australian Prudential Regulatory Authority (APRA) can require NAB to immediately convert NAB Capital Notes 3 into ordinary shares if NAB’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 10.2% on 30/9/18), or if it believes NAB needs an injection of capital to remain viable. In these distressed circumstances, conversion would most likely result in the holder receiving considerably less than $100 of NAB shares, as there is a cap on the maximum number of shares that can be issued. The cap will be advised shortly after the issue date and is expected to be around 20 shares per $100.

NAB also has an option to redeem (call) the Capital Notes 3 early on 17 June 2026 (in approximately 7.25 years’ time) by paying holders $100 per Capital Note.

Details of the issue are as follows:

NAB is also conducting a re-investment offer for holders of NAB CPS (ASX code NABPA). NAB CPS, which  pay a distribution at a fixed margin of 3.2%, will be called (redeemed at the $100 face value) if investors do not elect to re-invest in NAB Capital Notes 3. Payment will be made on 20 March.

How to invest

The offer is due to open tomorrow (Tuesday). Several brokers and financial planners are involved in the issue, including  Morgans, Morgan Stanley, Shaw and Partners and UBS. If you are investing via a broker or financial planner, many are receiving a placement fee of 0.75% and in some cases, may be willing to share some or all of this with potential investors.

NAB shareholders and holders of NAB Capital Notes, NAB Capital Notes 2, NAB CPS, NAB CPS II and National Income Securities can also access NAB Capital Notes 3 directly through a Securityholder offer at www.nab.com.au/ncn3offer . One word of caution for security holders is that the issue may be subject to a scale back, so bare this in mind when bidding.


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 regard to your circumstances.

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