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Understanding the extra return from hybrids

Avoiding complex investments is a good guiding principle for most investors. Bank hybrid notes are an exception to that rule. They are complex relative to plain vanilla shares and bonds, but their reward-to-risk ratio, and their defensive qualities are attractive. Investors should consider bank hybrids despite their complexity.

It can help to understand hybrid notes as a combination of low risk bonds plus embedded put options. It is the embedding of ‘deep out-of-the-money puts’ that make hybrids especially appealing to affluent investors. By way of an example, modelling of the value of these puts shows that investors in the CBAPD hybrid notes are getting a yield of about 1.30% per annum more than is justified by the risk.

Yield vs time to maturity for Big 4 bank hybrids

Source: Michael Saba of Evans and Partners.

Australia's four big banks each have several issues of hybrid notes which trade on the ASX. The graph above shows how the yield on these securities increases with their time to maturity. Comparable hybrid note issues by the banks are CBAPD, ANZPE, WBCPE and NABPD, which all have similar maturity dates.

CBAPD notes bought at a price of $97.10 will yield a total return of 5.35% per year to maturity (assuming they are called) at the end of 2022.

Why CBAPD notes and not other hybrid note issues?

I like CBAPDs because:

1. CBAPDs are by far the largest issue of hybrids in the market; with the largest turnover, which makes them more liquid and more rationally priced than other issues. The $3 billion of CBAPDs make up about 7% of the total $42 billion of bank and insurer hybrids listed on the ASX.

2. CBA hybrids are attractive relative to CBA shares in risk-versus-return terms. CBA shares are far more risky than CBAPD hybrid notes, but the grossed-up yield on CBA shares (7.8%) is only 2.4% more than the yield on CBAPD hybrid notes (5.4%). The same yield gap between the shares and the hybrid notes of the other big banks is over 3%, which suggests that the hybrid notes versus shares comparison is less favourable to hybrid notes in those banks.

The mandatory conversion provision in CBAPD

If Australia suffered a banking crisis in which many bank loans were defaulted on, then the shareholder equity of Australia's banks would be rapidly depleted. The equity of any firm is the buffer that allows it to suffer losses without going bankrupt. In a banking crisis banks would need to replenish their equity, and this is where bank hybrids come in. In a crisis, the banking regulator APRA can force the conversion of bank hybrids notes into shareholder equity by insisting that banks invoke the conversion provisions in their hybrid notes.

In a mandatory (APRA forced) conversion, the holders of CBAPDs would hand over their notes. In exchange, they would receive either:

- 6.4 shares, if the share price was less than $15.90 at the time of conversion or

- $101 worth of shares if the share price was more than $15.90.

The slightly rounded numbers were fixed at the time CBAPD notes were first issued, based on the share price at that time.

Assuming mandatory conversion will only occur if the share price is less than say $15.90, mandatory conversion provision are equivalent to CBA having the option to 'put' 6.4 CBA shares to the CBAPD note holders to discharge CBA's $100 liability to the note holder.

Or, equally, $15.90 of liability is discharged for every share put to the note holder by CBA, and $15.90 is what CBA receives for every put option exercised, being the 'exercise price' of the puts.

If in a crisis the CBA share price fell to $10, then the put options would be $5.90 'in-the-money' for CBA because CBA could hand over a share worth only $10 and discharge a liability of $15.90.

CBA's share price today is not $10, but at time of writing, $78.30. So, the puts embedded in CBAPDs are currently $78.30 - $15.90 = $62.40 'out-of-the-money' (OTM). They are 'deep' OTM puts.

Compensation investors receive for selling the embedded puts

If CBA exercised its put options when the share price is $10, then CBAPD note holders would suffer a capital loss of 6.4 x ($15.90-$10) = $37.75. So, the main risk that hybrid note holders face is the risk that the put options that are embedded in the notes will be exercised when the options are in-the-money. We can estimate how much compensation CBAPD note holders receive for bearing this risk, and whether that compensation is large compared to compensation for bearing CBA share price risk.

How much would the CBAPDs be worth if investors were certain that the CBA share price would never fall below $15.90. The notes would then be risk free. The price of the notes would rise to $111.70 to give a yield of 2.85%, which is 0.40% (40 basis points or bps) above the yield on equivalent Australian Government bonds. The extra 40 bps is for illiquidity of bank hybrids compared to Government bonds, guaranteed by the Federal Government.

But, hybrid notes are not risk free, because of the embedded put options. And, their price is not $111.70, but instead, $97.10. The discount of $111.70-$97.10=$14.60 is the price that new CBAPD investors are being paid for writing (selling) the 6.4 embedded put options. In effect CBAPD note holders are buyers of a risk-free note from CBA (for $111.70) and sellers of put options on CBA shares (for $14.60).

Option pricing theory using the Binomial Method estimates the value of the put option being $103.55, which equates to a yield of 4.04%. In the calculation, volatility of 40% is included as deep OTM puts should be valued with much higher probabilities of extreme changes in prices. Comparing the yield of 4.04% with the actual yield of 5.35% on CBAPDs implies that buyers of CBAPDs at current prices are getting about 130 basis points more yield than is justified by the risk they face.

Other risks on CBAPD

The risk of loss of capital in the mandatory conversion process is one risk, but other risks include that coupons are cut to zero (which for hybrid notes is not considered a default, and dividends would have to be cut to zero first). But, with a deep banking crisis mandatory conversion would occur anyway, although if this was not the case the results above (the 1.30% figure) only changes by a few basis points. There is also a risk that the notes will not be called in 2022, but this requires much wider analysis.

 

Dr. Sam Wylie is a Principal Fellow of the Melbourne Business School and a Director of Windlestone Education. Please seek professional advice on structuring and tax planning from a qualified accountant or financial planner. This article is general information and does not consider the circumstances of any individual.

11 Comments
Dr Sam Wylie
July 27, 2019

Hi Ed

I am glad you are reading my article on Hybrids in Cuffelinks.

To value any asset there are two steps:
Estimate the cash flows
Estimate the required return of investors

In the article I ask how much the CBAPDs would sell for if they were risk free.

Using the cash flows that were expected on the note until maturity (the 90 day bank bill swap rate in Sep 2017 plus the 280 basis points spread promised on the notes in the contract). Maturity is the 2024 maturity date.
Use the risk free rate until maturity (the 7 year Govt Treasury bond rate + 40 basis points) as the required yield of investors. This was 2.85%. The 40 bps extra is because even risk free bonds have higher yields, of about 40 bps more, if they are not issued directly by the Govt (for instance bonds that are guaranteed by the Federal Govt have higher yields than Treasury bonds).

What price would investor pay to get a 2.85 + 0.40 = 3.25% return on the notes. That price is $111.70.

Cheers
Dr Sam Wylie
Principal Fellow
Melbourne Business School

Ed
July 27, 2019

Good morning,

I’m hoping you might be able to help with a question I have about Sam Wylie’s article in the above subject line.

I know I’m going back nearly two years, however, in the section regarding compensation investors receive for selling embedded puts, Sam writes that the price of CBAPDs would rise to $111.70 if there was certainty that the CBA share price would never fall below $15.90.

Could I please ask for some detail around how the value of $111.70 was arrived at. I’m finding the article extremely useful and a great education piece however I am stuck on this point.

Any assistance would be greatly appreciated. Thank you.

Richard XTB Murphy
September 15, 2017

Hi Sam, does the low risk bond + written put idea cover all the features of hybrids? I'm thinking of this as a structured product you are building.

You've covered the written put investors have sold to the bank issuer, but should there (?) also be a written put with an unknown strike you've written to APRA? After all, it was the Euro regulator who exercised its put on the Spanish bank, not the bank itself. Or is that one option written to two parties?

And what about the fact dividends can be missed and be non-cumulative and/or garnished? Changing coupons/dividend is not a feature of a bond or a written put, and your structured product needs those additional features to be complete.

Plus the call date can be moved by either the bank or APRA so again that's not a feature of a bond or a written put. Maybe one of CuffLinks readers who has structured listed and unlisted structured products can tell us how you could fully replicate all the features of basel III tier 1 hybrids by building them from other instruments, but I wonder if a low risk senior bond + a written put gets you there. Perhaps a 'bond' with coupons that can be missed or garnished at the discretion of the issuer and its regulator, with a maturity date that can be moved by both bank and APRA + a couple of written put options?

Warren Bird
September 17, 2017

Spot on Richard XTB Murphy. When we set up what used to be called the Enhanced Yield Fund at Colonial First State (many years ago now!) we included hybrids in the universe. But we set up a very detailed due diligence sheet to work through all the complicated features of each of them so that their full set of risk and return characteristics could be modeled and compared with alternative assets and structures. Some passed muster, but most didn't.

Most that didn't, it was because a subordinated debt instrument was a much better value proposition. In the end that is because the issuers of hybrids and the investment banks who advise them are (a) looking for a cheaper funding source for the issuer than doing something simple - cynically, they're trying to rip off the investor - and (b) they strip large fees out of the issue. (Investors who hate paying fees should stay miles away from hybrids - you can't see them, but they're there and they're large.)

To say nothing of my mantra about how critical it is to diversify credit risk. Add all the other risks to your capital in hybrids and the percentage of each in your portfolio should be very small indeed. Having 4 or 5 hybrids is NOT diversification!

Sam Wylie
September 19, 2017

Warren When you say you modelled all the features of the hybrids, then what did your model look like? How did you model mandatory conversion? How did you get to a fair value price? It is good to be specific on these things.

Warren Bird
September 19, 2017

Sam, you're asking too much information. It's not my place to give away proprietary information of a former employer - the details of which I certainly don't remember all these years later anyway.

Your article pointed to some of the complexities and I am simply taking the point of your article a bit further, which is that there is a lot to look at to fully understand the structure of a hybrid to get a fully informed view of whether the prospective return is worth the risk. It's a more complex exercise than the typical retail investor or their advisers realises or even attempts.

Sam Wylie
September 19, 2017

Hi Richard Yes, there are a bunch of things I have not accounted for. The main issue not addressed in the simple analysis I put in the article is how quickly the CBA share price falls before mandatory conversion occurs. That matters a lot for hybrid investors. I ignored that affect in my simple model, but I am going to write about it in a separate article.

NR
September 15, 2017

See Christopher Joye in the AFR 01Sep17 regarding this analysis.
To clarify, Hybrids are a combination of subordinated debt securities (perhaps not "low risk bonds" as described above) and put options. One might question the appropriateness of retail investors selling long dated out of the money options packaged up in this manner. We note the distribution fees are significant and the Banks describe the capital raised as "cheap". At a minimum investors ought be aware impact of subordination and of the volatility assumptions underlying in order to determine if the complicated instruments are fair value for the risk. From a portfolio diversification perspective, an investor may prefer not to buy subordinated debt and sell put options on the same issuer.

Sam Wylie
September 19, 2017

NR The question here is whether hybrids are a combination of embedded put options plus sub notes, or alternatively, embedded put options plus risk free notes. Neither is exactly right. The problem with using subordinated notes is that it double counts the default risk. So, in a back of the envelope analysis like this, it is better to use risk free rates and add something for illiquidity and risks that the embedded puts don't capture.

Peter Dobrijevic
September 14, 2017

Hybrids are just low-yield equities. At issue, you would have been better off owning CBA than CBAPD: this was the intended consequence because directors of CBA should, and did, want a lower cost of capital on the issue, and consequently, a lower return for the investors. With respect to the calculated tax losses in the article, I suggest the readers refer to ITAA 1936 and ITA 1997. Investors should also get their licensed advisor to check the calculations, and confirm, in writing, what they find.

Sam Wylie
September 19, 2017

Peter, Low yield equities? That is obviously incorrect. They are hybrids between debt and equity. Hence the name. Regarding the checking by licensed advisor of the calculations -- if your licensed advisor can price put options using binomial trees, then give them a pat on the back. Sam Wylie

 

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