This article appeared in the April 2011 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.
Learn to achieve better yield through ASX Listed fixed interest securities.
By Brad Newcombe, FIIG
Step-up preference shares are the main type of hybrid issued by Australian corporates and are listed on ASX. With many hybrids still trading at significant discounts to face value, there are some exciting opportunities.
(Editor's note: The term "step-up" refers to the issuer's obligation to pay a higher margin above a reference rate, such as the 90-day bank bill rate, if the issuer does not redeem the security after a certain period. Simply put, this can see the yield on a hybrid increase by up to a few percentage points, and potentially provide higher returns for income-seeking investors.)
A hybrid security is a mix of debt and equity and can be structured in several different ways. Banks, for example, have been recent issuers of the converting preference share structure. Corporates, on the other hand, have in recent years issued a security with a structure known as a step-up preference share.
It is structured as a perpetual security, with no defined maturity but with a call date after a set time, normally five years. At this initial call date the issuer has a number of options.
Call date options
The first option is to redeem the security for face value, usually $100. This is the preferred option for investors who regard the instrument as a fixed-income security and expect their capital back at the first opportunity. However, since the global financial crisis many issuers have used other options rather than the market expectation of redemption.
The second option is for the issuer to exchange the hybrid into ordinary shares of the issuer. The exchange is normally done at a discount, usually 2.5 per cent, to the prevailing price of the ordinary shares, so the investor will receive a slight premium to the face value for their investment - $102.56 worth of ordinary shares in this example.
This small discount provides investors with an exit mechanism to sell the ordinary shares without incurring a capital loss. Although it is possible the price of the ordinary shares may drop by more than 2.5 per cent as hybrid investors cash out their investment, a 2.5 per cent buffer is more than sufficient in most cases to prevent a capital loss.
A third option is for the issuer to re-market the terms of the security, although this clause is rarely invoked. The main purpose of this is if the issuer is looking to set a new coupon margin for the securities below the stepped-up margin (see details below). However, since the GFC, this has become a redundant clause because of the vast increase in the cost of funding.
The funding costs factor
If the issuer chooses not to use any of these options, the default clause of a margin step-up is used. A typical step-up can be anywhere between 1 per cent and 2.5 per cent to provide issuers with an economic, not just a reputational, incentive to redeem the security at the first call date.
Essentially, this stepped-up rate is supposed to be a prohibitively expensive cost for the issuer, but since the GFC this has not always been the case. Many issuers have chosen to pay this stepped-up margin because of the substantially higher cost of funding, in lieu of redeeming the securities as investors initially expected.
Issuers have a range of other options available to them. With many step-up preference shares currently trading at significant discounts to face value, some are re-purchasing these securities through on or off-market buybacks. Other issuers are contemplating changing the terms of the hybrids, which is subject to approval by shareholders at a general meeting.
An example of a step-up preference share is the Goodman Plus Trust hybrid (GMPPA) issued by the Goodman Group. The security was initially issued in March 2008, paying a margin of 1.9 per cent over the bank bill swap rate. If the security is not redeemed at the first opportunity in March 2013, the margin on the hybrid will increase to 2.9 per cent over the swap rate.
Step-up or redeem?
The following table shows a selection of step-up preference shares currently on issue. As mentioned, some issuers may not choose to redeem the security at the first opportunity, so while the yields may look impressive (they are calculated on the basis they will be redeemed on the call date), they may prove to be illusory. (Editor’s note: YTM in the last column means yield to maturity).
Selection of step-up preference shares currently on issue
The current price of the securities gives an indication of the likelihood of a security being redeemed at the first opportunity. For hybrids trading close to face value, there is a good chance the issuer will redeem it at the first opportunity. However, for securities trading at substantial discounts to face value, there is a good chance the issuer will not redeem but instead choose to step-up the coupon margin.
The Woolworths hybrid (WOWHB) is a good example of a security that is likely to be redeemed. Woolworths recently issued five-year senior corporate debt at a margin of just 1.05 per cent over the bank bill swap rate, so it can access funding substantially cheaper than the 3.1 per cent over the swap rate it would have to pay if the hybrid was allowed to step-up. This likelihood of conversion is reflected in the security trading at close to face value.
Conversely, as current prices indicate, the PaperlinX hybrid (PXUPA) is likely to be stepped-up after its first call date of June 30, 2012. The company has relatively low debt but possibly would struggle to redeem the full $285 million of securities outstanding. PaperlinX has, however, flagged that it is reviewing its options for the hybrid, so a partial buyback of the securities (probably at a discount to the $100 face value) is possible.
Keep in mind that the discounted price of some of these securities is a reflection of credit risk. If the issuer goes broke, hybrid investors are unlikely to see a return in a liquidation of the company - one of the risks in sitting just above ordinary equity in the capital structure.
The other main risk is that the issuer may suspend distributions on the security. To get equity, rather than liability, treatment on a balance sheet - which improves the company's amount of equity and it's gearing ratios - there are two main requirements.
The first is that the security must be perpetual in nature, although call dates at the sole discretion of the issuer are allowed. The other is that distributions must be optional at the discretion of the issuer, and any missed payments are non-cumulative; the company does not need to make them up. If the payments were mandatory and/or cumulative, this would make them a liability and hence not meet the equity requirements on a balance sheet as defined by accounting standards.
Hybrid investors are protected from the issuer simply not paying distributions by a number of mechanisms. By far the strongest is a clause that the issuer will not be able to pay dividends to ordinary shareholders if distributions on the hybrid are not being made - know as a distribution stopper.
It is unusual, but not unheard of, for issuers to suspend distributions on their hybrids, usually at the behest of the company's banks looking to safeguard their position. In the past, PaperlinX suspended distributions for a year but reinstated them. Currently, the hybrid issued by Elders (ELDPA) is suspended although it is forecast to be reinstated in the last quarter of 2011.
Stepped-up preference shares
As mentioned, a number of issuers have chosen not to redeem their hybrids at the first call date and instead allowed them to step-up. The table below shows stepped-up hybrids currently listed on the market. (Editor’s note: Do not read the Capital Upside column in the table below as a guarantee of capital gains. It is based on an assumption of the hybrid being redeemed at its $100 face value, which may or not may happen in the near term. Talk to your financial adviser before buying hybrids based on the potential for capital gain.)
Currently listed stepped-up hybrids
Several of these securities are attractive investments. They typically offer investors a double-digit running yield with the prospects for capital gains - because of the discount they are trading at to face value - and are lower risk than equities in that they are higher in the capital structure.
Although these securities are perpetual in nature, they may still be redeemed by the issuer on any coupon payment date. As credit markets continue to return to normal since the GFC, issuers may look at redeeming these securities, resulting in a one-off capital gain for stepped-up preference share investors.
A good example is the Australand Assets Trusts (AAZPB). At a current price of around $94.50 it is offering a running yield of around 10.03 per cent based on a current annualised coupon rate of around 9.7 per cent. The margin of 4.8 per cent over the bank bill swap rate is an expensive form of funding in the current environment and if the company redeems the securities, investors are set for a one-off capital gain of 5.8 per cent.
Step-up preference shares potentially offer exceptional returns for investors, although that is dependent on whether the issuer redeems the security at the first call date. Potentially there are better returns available in stepped-up preference shares, which offer high running yield plus the prospects of capital gains if the securities are redeemed by the issuer.
About the author
Brad Newcombe is a senior research analyst at Fiig Securities Australia's largest specialist fixed-income brokerage house.
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.
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