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?

The best income-generating assets for your portfolio

Investing like Jerome Powell or the Future Fund

banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Warren Buffett changes his mind at age 93

This month, Buffett made waves by revealing he’d sold almost 50% of his shares in Apple in the second quarter. The sale not only shows that Buffett has changed his mind on the stock but remains at the peak of his powers.

Wealth transfer isn't just about 'saving it up and passing it on'

We’ve seen how the transfer of wealth can work well, with inherited wealth helping families grow and thrive for generations, as well as how things can go horribly wrong. Here are tips on how to get it right.

Welcome to Firstlinks Edition 575 with weekend update

A new study has found Australians far outlive people in other English-speaking countries. We live four years longer than the average American and two years more than the average Briton, and some of the reasons why may surprise you.

  • 29 August 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

Welcome to Firstlinks Edition 573 with weekend update

Steve Eisman, best known for his ‘Big Short’ bet against US subprime mortgages before the 2008 financial crisis, is now long and betting on what he thinks are the two biggest stories of our time: AI and infrastructure.

  • 15 August 2024

Latest Updates

Investing

Legendary investor: markets are less efficient and social media is the big culprit

Despite an explosion in data, investment titan, Cliff Asness, believes the market has become less efficient, not more, over his 34-year career. He explains why, and how you can take advantage of it.

Property

A housing market that I'd like to see

Our housing system isn't working, with prices and rents growing faster than wages, longer public housing waiting lists and more people are experiencing homelessness. Here are five ways to ease the crisis.

Retirement

It isn’t just the rich who will pay more for aged care

The Government has introduced the biggest changes to aged care in almost 30 years. While the message has been that “wealthy Australians will pay more for aged care”, it seems that most people will pay more, some a lot more.

SMSF strategies

Meg on SMSFs: At last, movement on legacy pensions

Draft regulations released this week finally provide the framework for unwinding legacy pensions cleanly and simply for members who choose to do so. There are some caveats though, including a time limit.

Investment strategies

A megatrend hiding in plain sight: defence

Global defence spending has inflected higher, bringing huge opportunity to a group of companies that have already outperformed broader market indices over the long-term.

Investment strategies

The butterfly effect, index funds, and the rise of mega caps

Index fund inflows to the US market are relatively tiny. Yet a new research paper suggests that they have distorted the size of the market's largest stocks to a surprising degree.

Investment strategies

Options for investors who don't want to sell overpriced banks

The run-up in Australian bank stocks has some investors confounded: do they continue to hold them in expectation of further gains - or sell and take profits now? There are alternative options to consider.

Sponsors

Alliances

© 2024 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.