Trading margins for the majority of ASX listed notes (hybrids) of the four major Australian banks have been rising for most of the past year and a half, the low point being the 18th of August 2014 PERLS VII (ASX code: CBAPD) transaction issued at 280 basis points over swap. The peak in trading margins was reached on the 15th of February 2016 close to the announcement of CBA’s PERLS VIII transaction (ASX code: CBAPE). At this time some of the more recent major bank hybrids were trading as high as a margin of 590 basis points over swap. Whilst hybrid trading margins appear to represent better value now compared to fifteen months ago, investors need to accept that during times of stress trading margins could widen significantly further from current levels as we saw during 2009. Chart 1: Source BondAdviser as at 14th March 2016 Apart from a small number of notable exceptions BondAdviser over the past year has consistently recommended short to mid dated hybrids (i.e. an expected call date of less than five years) . We have also preferred subordinated (otherwise known as Tier 2 hybrids) over preference shares (otherwise known as additional Tier 1 hybrids) due to their superior ranking above preference shares in the capital structure of the banks. Despite short and mid dated hybrids rallying since the PERLS VIII book-build, longer dated hybrids have barely moved as shown in chart 2. Chart 2: Source BondAdviser as at 21st March 2016 Increased hybrid and equity issuance by the banks since 2014 has led to ongoing uncertainty and supply side pressures for investors. Investors in Basel III compliant hybrids are taking more equity risk than older hybrids but this environment is the new normal for what the regulators require of the banks. Crucially for debt and hybrid investors the end result will ultimately mean less capital leverage and more risk controls. The big four banks have historically exercised their calls at the first opportunity (otherwise tainting future ability to “tap” the retail investor), past experience does not indicate future actions. Assessing the likelihood that the banks will be able to call a Basel III compliant hybrid at the expected call date means that it is even more critical that investors take a view on;
- The ability and cost to issue replacement hybrids at the first call date; and
- Regulators approving the call based on capital adequacy levels.
Chart 3: Source BondAdviser as at 21st March 2016 Chart 3 shows how the trading margin of preference share hybrids have moved from the 12th February to the 17th March 2016, again showing that short and mid dated securities have to date outperformed longer dated ones. Should investors start to consider buying longer dated hybrids to capture any potential delayed rally? Reasons to buy the long end:
- Post the GFC spike in major bank tier 1 hybrid trading margins, the trading margin range has been between 2.5% and 5% on average, therefore in the absence of another GFC style banking crisis one could argue these securities are at the cheap end of their range;
- Bank capital levels have improved as;
- APRA flagged banks will need to hold higher amounts of capital against their residential property loans;
- APRA has now agreed with the Financial System Inquiry (FSI) that Australian banks should be in the top 25% globally in relation to capital ratios;
- By 2017 preference shareholders will have a significantly amount of equity below them due to improvements in capital levels which should decrease both the probability of default and the loss given default;
- As we have already seen the CBA replaced PERLS III with the PERLS VIII issue investors will be taking on longer expected call date risk if they decide to roll into new securities. Both Westpac and the ANZ are expected to follow the CBA in replacing existing hybrids during the course of 2016 so we can expect more supply of the new style Tier 1 hybrids. The question will be whether issuers will be willing to ‘upsize’ transactions despite the higher margin expected to be paid on these securities.
Reasons to avoid the long end:
- Loan delinquency rates remain extremely low due to both the low interest environment and the low unemployment rate. As banks continue to pass on higher funding costs to borrowers this may subsequently increase the incidence of mortgage stress over time;
- The banks will continue to be placed under both regulatory and competitive pressures (e.g. FinTech companies expected to have both lower overheads and more flexible and cost effective technology). Over the mid to longer term banks will have to walk the fine line between maintaining margins or to exit non-core business streams as both compliance and capital constraints lower the net return on equity for these business units;
- Looking at the major bank Tier 1 hybrid credit curve, investors are still not being completely compensated for taking on risk beyond four years of credit duration as the curve remains relative flat (see Chart 4);
- The banks will naturally replace all pre Basel III compliant hybrids with at least a new 4 to 7 year expected call date hybrid securities that will have Basel 3 (and eventually Basel 4) non-viability and capital triggers embedded in the terms and conditions. This means that investors do not have to fully embrace these terms and conditions until after the last of the pre Basel 3 compliant securities have been called.
Chart 4: Source BondAdviser as at 21st March 2016 Basel 3 compliant hybrids generally exhibit more equity than debt characteristics compared to previous securities. As ‘credit’ is about avoiding losers, investors should take note of the finer detail embedded in these securities. While it is good for a company to have solid growth prospects for equity investors it is not so essential for credit investors. A credit investor is better served building a portfolio of securities where there is a very low probability of deterioration both from a capital and income perspective. Picking seven out of ten winners is likely to make an equity manager successful as the extra alpha generated by the successes are statistically usually enough to cover the less successful investments. Credit managers as a general rule do not have the same margin of error to cover the same mistakes. Other considerations;
- The size of the issue and therefore the potential impact upon secondary market liquidity, i.e. the larger the issue size the higher the premium investors should demand (as we saw with the CBA PERLS VII issue where issuer supply was greater than investor demand);
- Where are we in the credit cycle, i.e. if a new issue is brought to market whilst credit spreads are wide they are more likely to provide longer term value than an issue that is brought to the market when credit spreads are at a low point;
- Looking at the details of the securities beyond the expected call date to determine whether the margin on offer is sufficient to compensate differences in the maximum exchange percentage compared to other securities;
- If some securities have a 50% regulatory trigger (some may have this set at 20%) and APRA orders a particular bank’s preference shares be converted to ordinary equity, some preference holders will get fewer ordinary shares than other preference shareholders;
- Conversely, if a particular preference share has a lower value weighted average price (VWAP) on conversion;
- The bank share price could be halved from current levels;
- All other hybrid preference shares would be blocked from mandatory conversion and would miss their first call dates; but
- The lower VWAP preference share would still pass its mandatory conversion test giving investors a realisation event, whilst other securities are stuck without one for an indeterminate period.
- The fact that the banks have yet to reduce their equity payout ratios as this is an obvious way to further enhance the common equity ratio and maintain top 25% global capital ratio status;
- The additional amount of bank capital raised over the past year also lends further support to hybrid investors and is certainly a positive.
In summary: Investors need to look at the pricing differential between shorter & mid dated preference shares compared to longer dated issues and consider the embedded structural differences between pre Basel 3 compliant securities and Basel 3 compliant securities before investing. While we do remain cautious of longer dated hybrids (as the hybrid credit curve remains relatively flat once you go past four to five years), the trading margins of longer dated preference share hybrids are as wide as they have been since the GFC. We can see the merit of extending the overall credit duration of a hybrid portfolio by holding a small percentage of longer dated hybrids but investors need to look at where individual hybrid securities are pricing relative to the hybrid credit curve and against their peers. For example, why do some investors believe that the new CBA PERLS VIII (CBAPE, issued at a margin of 5.20%) is more attractive to the ANZ issued Capital Note (ANZPD) that traded at a margin of 5.47% when the CBA deal was announced? Are the differences in the underlying credit of the two banks and the finer details contained within the structure of the two securities enough to justify why one trades at a premium/discount to the other considering there is only a month’s difference in their respective expected call dates? These are questions all credit investors should continually consider when investing in these markets.