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Hybrids – The Search for Yield Continues

The remarkable turnaround in performance of major bank hybrids (also known as Tier 1 securities) continued last week post the Westpac Capital Notes 4 book-build. One market participant declaring “this is the heaviest demand for a hybrid I have seen in 3 years here”.

 

Whilst the first hybrid issue of 2016 (issued February) proved to be the catalyst for investors to revisit this asset class. The decision by the RBA to reduce the official cash rate to 1.75% has further stimulated demand as the search for yield becomes an increasingly difficult task.

 

A third supporting factor is concern that bank dividend growth may slow going forward. This was partially confirmed during bank reporting season in May with the ANZ Banking Group being the first to reduce their interim dividend to preserve capital. The banks reported generally flat net interest margins (NIM) and have laid the groundwork for the expectation that bad and doubtful debt provisions will continue to increase (albeit off a very low base). Global and domestic bank regulators are also expected to endorse further rule changes which would require the banks to hold higher levels of capital.

 

In the linked chart (click here) major bank AT1 hybrid yields (to call) have moved since May 2007, compared with quarterly major bank dividend yields, 3 month term deposits, the RBA cash rate and the 3 month bank bill swap (90-BBSW) rate.

 

Despite the intrinsic risks associated with the terms and conditions of hybrid securities, with low interest rates and falling dividends it is no wonder some investors are attracted to a yield of around 7%.