Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 316

Why bank hybrids are far too expensive

Yield chasing has spilled into nearly every asset class, with Australian listed bank hybrids no exception. The current average margin of bank bills at +2.40% is close to the lowest level for at least seven years. For institutional investors, there are some obvious alternatives that are both lower risk and higher returning. For retail buyers, the direct alternatives are fewer but nonetheless there are ways to receive a better return whilst taking the same or less risk.

What is a bank hybrid?

A quick description of the security types is useful for a fair comparison. The two types of securities captured by the moniker of bank hybrids are:

1. Subordinated debt (technically tier 2 capital) is the security type that ranks directly below senior debt and has interest payments that are compulsory unless the bank is insolvent. ASX:NABPE is the only listed security of this type from the major banks it is highly likely new issues will come soon (note, all the five-letter codes in this article are ASX codes).

2. Preference shares (technically additional tier 1 capital) rank below subordinated debt. The major banks currently have 19 of these securities listed on the ASX with the largest for each major bank being ANZPG, CBAPD, NABPF and WBCPG. Preference shares are not debt securities and they receive discretionary dividend payments which the directors or the regulator (APRA) can stop even when the bank remains solvent.

The structural weaknesses of bank hybrids

Bank hybrids include a range of issuer-friendly terms such as:

  • The ability to delay (subordinated debt) or perpetually defer (preference shares) the repayment of the securities if the bank is in financial difficulty or if the share price falls below a threshold
  • The potential to be converted into equity that has little or no value
  • The lack of equity control rights, for instance being able to vote at shareholder meetings
  • Limited covenants that protect the investor’s position
  • Higher drawdowns than standard senior ranking bonds in times of market turbulence
  • Limited liquidity in times of financial stress and for larger amounts

Some financial advisers tell their clients that bank hybrids will not suffer a capital loss as the Australian Government will never let a major bank fail. This is a misunderstanding of the reason these securities exist. Bank hybrids are a protection mechanism to ensure that the Australian Government does not use taxpayers’ funds to bail out a bank. It’s like the safety features in a car. The crumple zones and airbags exist to protect the people, not to ensure that the car isn’t damaged. If a major bank was in financial difficulty, APRA has the power to convert hybrids to equity or to completely wipe out their value.

Recent changes impact bank hybrids and relative values

Earlier this month, the regulator APRA released its determination on how much additional hybrid capital, and the major banks need roughly $20 billion of subordinated debt each year for the next four years. This additional debt will be sold to institutional investors and issued as ASX-listed securities. Westpac and ANZ have both already issued institutional subordinated debt into strong demand.

The most recent subordinated debt issue was by ANZ on 19 July and it was priced at bank bills +2.00%. This is not far away from the average margin of listed major bank preference shares at bank bills +2.43%. This is scant additional return for the major increase in risk, particularly the risk of dividends being stopped whilst the bank is still solvent. Whilst this comparison is between an institutional security and the more retail-orientated listed hybrids, many large investors have both options available to them.

Alternatives to bank hybrids

Whilst some might question whether the relative value between subordinated debt and preference shares matters, the interest rates available elsewhere makes both options look miserly. Institutional investors can look to securitisation, syndicated loans and marketplace lending opportunities for a better risk/return outlook.

Retail investors can also take advantage of online savings accounts, marketplace lending directly or various other debt sectors accessed via listed and unlisted managed funds. Here is a quick summary of four alternatives.

1. Securitisation

The most relevant debt type that demonstrates the poor value in bank hybrids is ‘non-conforming’ securitisation. Investors in the subordinated AAA tranches are often receiving margins equal to or better than the margins on BBB-rated major bank subordinated debt. As well as a much higher credit rating, these securities have a shorter tenor and a history of lower drawdowns in market downturns. For an equivalent BBB rating, securitisation tranches have been issued at around bank bills +4.30% this year, more than double the margin on the recent ANZ subordinated debt issue.

Comparing securitisation to preference shares isn’t an apples and apples comparison. The predominantly equity features of preferences shares, notably the ability for the directors or APRA to turn off dividends, means they cannot be fairly compared with a debt instrument that has non-discretionary repayments. Whilst ratings agencies do rate some of these securities (e.g. Standard and Poor’s rates the CBA preference shares at BB+) these ratings ignore most of the risks created by the non-debt features of preference shares. Once these features are included, preference shares arguably have a risk profile more in line with a B rating for a standard debt instrument.

Either way, bank bills +2.43% for preference shares compares poorly to bank bills +6.30%/7.75% (BB/B rating) for securitisation issuance this year.

2. Marketplace lending

Institutional and retail investors can both access marketplace lending (also known as peer-to-peer lending) via a growing number of online platforms. There’s a mixture of residential and commercial property secured loans available, as well as unsecured business and personal loans. For more conservative investors, loans backed by residential property with an LVR of 60% or less typically yield 5-7%. Commercial property loans, business loans and personal loans usually come with higher yields. Investors in riskier loans should be expecting to lose a portion of their total return when some of the borrowers default and should set their return expectations accordingly.

3. Online savings accounts

Retail investors have a profound advantage over institutional investors when it comes to rates for online savings accounts. NAB’s online subsidiary Ubank, for example, has the best at 2.41%, requiring only a $200 monthly deposit. There are other options with higher rates, but these have restrictions on withdrawals, spending requirements or are only introductory rates. Whilst this rate doesn’t seem that high, note that two major bank preference shares, NABPC and WBCPF, are both trading with a forecast yield to maturity of less than 3%.

4. Managed funds

Retail investors that cannot access securitisation, syndicated loans and various forms of private debt directly have a growing number of listed and unlisted fund options. As these types of securities are typically illiquid, care should be taken to (a) choose managers with a long track record of managing these assets well and (b) invest in a fund with a suitable liquidity profile for the asset type. Funds that offer daily liquidity whilst investing in illiquid securities have a history of blocking redemptions in substantial market downturns, as occurred in 2008-09.

Listed Investment Companies or Trusts meet liquidity demands via a sale of the units on the ASX rather than selling fund assets at prices that may be below their long-term fair value. Listed debt funds include GCI, MOT, MXT, NBI and QRI with these funds having various debt types, risk profiles and fee levels.

 

Jonathan Rochford, CFA, is Portfolio Manager for Narrow Road Capital. This article is for educational purposes and is not a substitute for professional and tailored financial advice. This article expresses the views of the author at a point in time, which may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views.

RELATED ARTICLES

Is it time to sell bank hybrids?

Investing like Jerome Powell or the Future Fund

Worried about low rates, SMSFs drop banks and diversify

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.