This article appeared in the September 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Rising demand for income investments is driving strong growth in the ASX Interest Rate Securities market.
By Michael Saba, Evans & Partners
The huge demand for yield investments this year has seen the Australian Securities Exchange become a major market for the issuance of bonds and hybrid securities. The size of the ASX interest rate securities sector has increased by more than 40 per cent in the past 12 months to more than $30 billion of issuance. Turnover has increased correspondingly.
[Editor's note: To learn about the features, benefits and risks of ASX-listed interest rate securities, do the free online ASX interest rate securities course.]
A major feature of the new issuance is the popularity of other traditional yield securities such as senior and subordinated bonds, in addition to the traditional hybrid securities such as preference shares and convertible notes. This gives investors the choice of a range of securities in the capital structure and their associated different risk profiles (see table below).
Table 1: Range of securities and their associated risk profiles
Source: Evans & Partners
Additionally and importantly, the issuance has been from a variety of companies, especially from outside the banks. The net result is that investors now have a growing range of securities from a growing range of companies. Some companies have multiple issuance of listed bonds and hybrids, such as Commonwealth Bank.
One newer form of security listed in 2012 has been the subordinated note. There have been two forms issued, the first type from banks such as ANZ, NAB and Westpac. These are very similar to the typical form of bank subordinated debt issued in wholesale markets, with a 10-year life but probable repayment after five years.
They offer holders a higher coupon rate than a senior bond but lower than a hybrid. The three issues so far have been floating rate in style with a coupon rate of 2.75 per cent above 90-day bank bills. They have shown very low pricing volatility and are a good cornerstone holding in a portfolio of ASX bonds and hybrids.
[Editor's note: Do not read the ideas in this story as investment recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article.]
The second newer form of security has been from industrial companies such as Origin, AGK, Colonial, Tabcorp, Woolworths, and recently Caltex, APA and Crown. These securities are typically over 25 to 50 years with the issuer having a repayment option in about five years. The issuer gains favourable balance sheet treatment from rating agencies and there is a big incentive to repay the issue at the first call date (about five years), otherwise the favourable treatment ceases.
All issuing companies flag their intention to repay at this time rather than continue the issue long-term. Another incentive is that the issuer is paying a high coupon rate on the debt, more than would have to be paid if the issue was simply five years to maturity.
However, the potential longevity cannot be ignored. Investors must analyse the company's five-year and long-term prospects, looking for business stability, continuity and the company's ongoing requirement to use the capital markets, which is important because that marketplace will view non-repayment at five years harshly. On balance the investor is being paid a higher coupon as compensation for the longevity risk.
Our preferred exposures of the recently issued subordinated notes are Colonial finance (CNGHA) and APA Group (the soon-to-list AQQHA).
As expected, the markets have been heavily influenced by European banking events and the level of credit market spreads. In addition, the large issuance on ASX has caused pricing volatility as investors often sell current holdings to fund new issues.
This has created opportunities to buy oversold bonds and hybrids; for example, the Suncorp mandatory convertible preference share (MCPS), which is trading well under face value and is due to be repaid in June 2013.
Repayment or conversion (at the company's choice at a 1 per cent discount) will mandatorily occur if the Suncorp share price is above $7.98. Although the price is currently $8.80, it has been under $8.00 in recent months. If the price is below $7.98 near maturity, Suncorp can still choose to repay in cash. However, if the issue does continue past June 2013 the coupon rate remains the same at 3.20 per cent above bank bills (including franking).
Other oversold examples are the step-up hybrids issued by several banks, namely CBA (PCAPA) and WBC (WCTPA). The market is pricing these securities with a high probability of step up in 2016. However, we expect these securities to be repaid in 2016 and not step up the coupon. This is based on the impact of new Basel III banking regulations that now consider the step-up style of securities not to be appropriate in banks' capital structure.
Hence we expect the local regulator, the Australian Prudential Regulation Authority (APRA), to require these securities to be bought back at the first possible date - the step-up date in 2016. Currently these securities are trading at a deep discount to face value, offering margins above bank bills of well over 4.5 per cent (basis repayment in 2016), whereas most other bank hybrids are trading with margins between 3 and 3.5 per cent.
We expect APRA's attitude to cause a re-rating of PCAPA and WCTPA in the next six months so they trade at margins closer to that of a typical MCPS from these banks. This would result in a capital price increase of 3 to 4 per cent. As always, check the yields and trading margins from your broker before making any investment.
Government bonds to be quoted
Another exciting development for the market in the next six months will be the quoting of Commonwealth Government bonds on ASX. These may trade in a form of depository receipt but will, in effect, give holders the exposure of holding a government bond and be available in much smaller parcels than required in the wholesale markets. A key point will be the accessibility via ASX, with investors able to use a standard broking account as they currently do for investment in bonds and hybrids.
Commonwealth Government bonds are nearly always fixed-rate, hence investors will have surety of a coupon return. However, the capital price will be subject to general variation in interest rates. Details are still being fine-tuned by the regulators but it seems finally that listing will occur.
About the author
Michael Saba has covered Australian hybrid securities for more than 15 years at a number of Australian broking houses. He specialises in analysis and sales of derivatives to institutional clients, and polled No. 2 in his sector in the 2009 BRW East Coles Survey. He is Head of Derivatives at Evans & Partners in Melbourne.
ASX Interest Rate Securities provides useful information for those who want to learn more about fixed-income products, such as:
- Corporate bonds
- Floating notes
- Convertible notes
- Hybrid debt securities.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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