Solid relative performance from hybrids expected

Photo of Christopher Joye, Coolabah Capital By Christopher Joye, Coolabah Capital

min read

Hybrid fundamentals look reasonable in historical context – but understand the risks.

In what was a poor year for global financial markets, and equities in particular, the ASX hybrid market has delivered reasonable performance in the face of a number of shocks.

By hybrids we are generally talking about preferred equity securities, also called capital notes or convertible preference shares, although some like to add in subordinated bonds issued by banks and insurers.

(Editor’s note: To learn more about the features, benefit and risks of hybrids, take the free ASX online Hybrids course.)

Between 1 January and 7 December 2018, the Solactive ASX Hybrids Index returned 3.6 per cent, including franking (or 2.2 per cent without). This compares to a 2.9 per cent loss for Australian shares, including dividends, and a much more miserly 1.8 per cent total return for the senior-ranking, floating-rate notes issued by Australian banks.

The single biggest shock confronting the hybrid market was the announcement in March by the ALP that if it won the federal election it would eliminate cash refunds on franking credits for investors who pay no tax, or insufficient tax to utilise the credits. It subsequently revised this policy to carve out all pensioners and charities.

Since more than 90 per cent of all investors pay tax, and can use franking credits, this policy appeared to cause a temporary disruption between 15 March and the end of May.

Over that time there was much higher than normal secondary trading and a large increase in the credit spreads offered on five-year major bank hybrids, which blew out from about 300 basis points (or 3 per cent) above the quarterly bank bill swap rate to about 410 basis points over (or 4.10 per cent).

This bank bill rate is currently around 2 per cent, so you need to add these two numbers together to get a sense of a hybrid's total expected return.

Spreads then normalised back to around 325 basis points over at the end of August, and have since moved wider again on the back of a sudden spurt of new issuance in the form of synchronous CBA and Westpac hybrid deals in November. Both issues were launched to refinance existing hybrid maturities (CBAPC and WBCPD respectively).

Judging by investor demand – large order books resulting in only 15 per cent allocations for the new Commonwealth Bank deal and 60 per cent allocations for Westpac’s security – the market had moved on from its concerns about ALP policy.

It is certainly true that if anyone who is worried about having returns diluted by not being able to claim cash refunds, sells their hybrids to investors who can use the franking credits, these securities should continue to trade on a franked basis over the long run.

In the meantime we will probably get more volatility, which should create investment opportunities.

Positive technicals for hybrids

What is interesting about the outlook for hybrids as we head into 2019 is the positive supply technicals. First, we have seen the banks replace many of their ASX subordinated bonds, such as SUNPD, ANZHA, WBCHA, WBCHB and AMPHA, with over-the-counter securities, which is shrinking the total listed universe.

Next year only one major bank hybrid is expected to mature: NABPA on 20 March. This will presumably be refinanced with a new NAB hybrid (NABPB) at the same time as about $1.45 billion of cash coming back to investors through the repayment of the WBCPD and NABPA securities (after rolls into new deals).

This is on top of about $1 billion recently paid to owners of CBAPC (after rolls), $325 million to AMPHA holders and $770 million to SUNPD investors, to name a few recent hybrid and subordinated debt maturities.

After the federal election, expected in May, one of the four majors might use the second half of the year to smooth out their future hybrid maturity profile through a new domestic issue. It is also possible they will seek to raise hybrid capital in the US-dollar institutional market, which has historically had an enthusiastic appetite for issues from the likes of ANZ, Westpac and Macquarie.

At the time of writing, five-year major bank hybrids were paying about 387 basis points above the quarterly bank bill swap rate for a total expected return of almost 6 per cent, inclusive of franking.

In 2007, major bank hybrids offered spreads of only 125 basis points above bank bills despite the big banks’ risk-weighted equity capital ratios being about half what they are today.

In the post-GFC period we have seen hybrid spreads compress as tight as around 240 basis points, or some 147 basis points below current levels. Today's risk premia therefore appear reasonable in an historical context.

About the author

Christopher Joye, with Darren Harvey, founded Coolabah, an independent, absolute-return active credit manager based in Australia. With more than $2.3 billion in funds under management, it is responsible for managing Smarter Money Investments portfolios and other institutional mandates. Since inception, Coolabah’s strategies have been among the best performing of their peers.

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