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How risky are bank hybrids and are they misrepresented?

Question from Rob Prugue: Bank hybrids and other investment securities are NOT term deposits. Corporate notes, convertibles and debt issued by many banks are being touted by some as akin to term deposit. Oh really? Hybrids and convertibles as term deposits?  If they sincerely believe this to be true, what on earth are they doing advising. And if they know it’s false, why don't they just say so?

Here’s a perspective from Philip BayleyPrincipal, ADCM Services. This comment first appeared in Banking Day.

Why has the listed bond market developed as a risky, high yield market?

The vast majority of the funds being invested in high yield notes are coming out of self-managed superannuation funds that are intended to provide for beneficiaries’ retirement. Should regulators be concerned that the listed bonds are a risky, high yield market? The answer is yes.

The regulators, issuers and other market participants are well aware of the risks posed by the notes and yet some mums and dads can’t get enough. Earlier this month, NAB launched its second converting preference share issue for the year and, just as with the first issue in March, demand was sufficient to allow NAB to double the size of the issue to A$1.5 billion.

What is the attraction of a hybrid security that offers all the downside risks of equity for little reward? Is there an element of mis-selling in the marketing of these instruments?

Much emphasis is placed on the instruments offering a dividend of 325bps over the bank bill rate, in the case of the NAB CPS II. This sounds like a high yield but at current bank bill rates, it means an annual return of about 4% plus franking credits.

Do mums and dads realise that they are being targetted for these offers, because institutional investors would demand a margin over the bank bill rate that would be closer to twice the size of the one on offer? Institutional investors have a much clearer understanding of the equity-like risks that the instruments entail.

Clearly, retail investors do not have access to the same level of information available to institutional investors and for the most part, do not have the same level of understanding. In NAB’s case, many mums and dads simply perceive the converting preference shares to be a better yielding alternative to a term deposit.

Retail investors rely to varying degrees on the recommendations of their financial planners and advisors, who in the case of the former at least, rely on the research houses to provide research and recommendations on these instruments. And while institutional investors have access to credit ratings to help inform their investment decisions, very few issuers of listed bonds have chosen to have their bonds rated.

In fact, credit ratings have been actively avoided by issuers of listed notes. The wholesale market demands credit ratings but in the listed market issuers see ratings as an unnecessary expense and who wants to highlight the risks involved anyway?

This attitude is underlined by the spate of unrated, unlisted bonds that have been issued to supposedly 'sophisticated investors' this year. This is something else that the financial system inquiry will no doubt be concerned with, in relation to the development of the corporate bond market.

Sophisticated investors receive none of the prospectus provision protections provided to retail investors. Under regulation 6D.2.03 of the Corporations Act a sophisticated investor is defined as a person with net assets of A$2.5 million or more or whose gross annual income in the last two years has been at least A$250,000, as certified by their accountant.

These days neither test is particularly hard to meet, and who says they know anything about investing anyway? Having assets or a good income does not an investment professional make.

Do the sophisticated investors who have bought the unrated, unlisted bonds offered realise the credit quality of each of the issuers would likely be assessed as being in the single B category by any of the three major credit rating agencies? This is well into junk territory, so let’s hope the yield on the bonds provides sufficient compensation for the risk.

The Financial System Inquiry needs to consider ways to increase the flow of reliable information to investors, both at the time of making the investment decision and afterwards. Ideally, this information will be made freely available to investors by the information providers, and only by those providers that have joined the Financial Ombudsman Service.

Such a requirement would go a long way towards to creating well-informed investors, 'sophisticated' or not, and promote a listed corporate bond market in the form originally intended.

 

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5 Comments

Sulieman Ravell

January 14, 2014

Hi Warren

I should firstly say I'm in agreement with you that I would rather invest with bond managers (for the majority of my fixed income) and perhaps I should re-qualify my relative to risk statement. This is on the basis of holding to maturity. I hold them because they misprice and behave differently to other asset classes and regularly misprice allowing us to pick up added returns. The returns for the risk then become more worthwhile. I suspect that if bond managers were able to take advantage of these pricing movements, they would, unfortunately, any manager worth his salt is unable to take a reasonable trading position without moving the market against themselves.

I'm also in agreement that investors need to look beyond a household name, tail risks are becoming more frequent. A good reminder for retail investors would be to consider a company like RBS in the UK, which was the UK equivalent of CBA, perceived as indestructible. The key difference is arguably just geography.

Having said that, I think its a little unfair on the hybrid sector to say there are several bond funds that are highly competitive with (retail) hybrids. The market has been too narrow until late to show comparable performance and therefore the only comparable becomes the current yields on offer. In which case, its unlikely you'll get anywhere close to hybrid yields. Factor in the 0.5%pa (plus potentially a platform fee and adviser fee), you can see why retail clients flood to direct hybrids and why they often feel their (non-equity) investment options are limited to TDs or hybrids.

I think the behaviour of the asset class itself provides value in addition to just the yields. Negative correlation allows you to take additional risk in other parts of your portfolios and allocating more to higher risk assets such as equities.

If it was a case of just investing in investments that were cheap why would anyone be allocating to bonds when TDs are still paying historically (relatively) high returns for retail investors. Fund managers don't because they can't access the same rates.....

Warren Bird

January 11, 2014

The way I look at things is that if I don't think something is value for money I don't buy it, even if it means accepting a lower yield and potentially lower return. Buying poor value is a sure way to end up losing capital.

But, I am not saying that hybrids don't offer value for risk. Many actually do. I'm simply saying that investors need to be aware that it's not just a case of saying, "company XYZ is a household name so it's hybrid must be safe". The true nature of the security's risks need to be understood and evaluated. And then you need to limit your individual exposures so that if a tail risk event happens it doesn't wipe you out.

There are several bond funds which even net of fees are highly competitive with hybrids. I'm not here to market any in particular, but most of the platform providers who've done manager research have quite a few to choose from. I'd rather pay a fee of 0.5% or a bit more for a credit risk portfolio to be well managed and diversified than buy half a dozen hybrids and hope that we don't get tail risk events.

Sulieman

December 28, 2013

Whilst I agree that hybrids don't offer value for money relative to the risk, what are the alternatives for retail investors?

A bond fund that charges an 0.5-1%pa fee? We're then looking at TD returns for greater risk

The other attraction is that hybrids behave completely differently to both equities and bonds and often misprice in the secondary market.

So whilst I agree, the tail risks are much greater than investors understand, I think there are some attractions to what I consider a separate asset class

Warren Bird

December 13, 2013

During the second half of 2012 I did a series of roadshow presentations to advisers on hybrids. Main message was about tail risk. Sure, most of the time you will get paid the reasonably high yield by issuers who you are familiar with. But if something goes wrong, there is a lot of downside risk. The question has to be asked: if the things that make it a hybrid rather than a corporate bond are triggered, can I live with the consequences?

Consequences including: conversion to equity in a company that might be going backwards fast; outright capital losses from a default; or conversion from a security expected to mature soon to something that is perpetual.

The latter is one of the least understood. EG bank hybrids are callable after a moderate period, such as 5 years. Most people expect the bank to call the bond, so they compare it to a 5 year TD. But, it is not actually the bank's say whether they can call it or not. It is APRA's. If APRA believes that bank capital is under pressure - say from a sharp fall in house prices and pick up in mortgage arrears - then they will override the bank and force them to keep the hybrid to shore up their capital.

Now APRA doesn't give two hoots about what this does to an investor's portfolio. APRA only cares about bank solvency so that depositors are protected. Hybrid investors are in the firing line to be adversely affected.

None of this means you should avoid hybrids. But you do need to understand the tail risk of owning them. As they say in the classics, there's no such thing as a free lunch. Hybrids pay higher yields for a reason.

Whether they pay high enough to be good value is another question that I'm not going to discuss here beyond saying that some do and some don't. (My mate Rudi Minbatiwala at Colonial First State is pretty good at working out the answer to that question.)

Mark

December 13, 2013

Good article and I agree with many of the sentiments; basically on a risk-adjusted basis I do not believe that the recent bank hybrids offer attractive returns.

However, I would note that your statement, "credit ratings have been actively avoided by issuers of listed notes" is not true. Largely thanks to ASIC, the three major credit rating agencies have not applied for and do not hold a retail license in Australia, so are explicitly prohibited from offering credit ratings on any product that is targeted towards retail investors.

I agree that this is a crazy situation and should be addressed sooner rather than later. The information that the rating agencies would impart would go some way to filling the vacuum, which is currently filled by conflicted advice from various parties. Having said that, investors also need to be educated to look beyond the headline yield/return and adjust that for the associated risks involved.


 

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