Omar´s Outlook - Sep 2013
Hybrid Securities: The Good, the Bad & the Ugly
As most of our long-term investors will know, AAS has in the past been using relatively high levels of overall portfolio allocations to ASX-listed hybrid securities from quality issuers.
This asset class has been consistently amongst the best performing since the dark days of the GFC, delivering good ongoing income substantially in excess of term deposits, and coupled with low volatility and typically also with a fixed redemption date. An average annual rate in excess of 8% has been achieved since inception over the last 4 years (July 2009) – as shown in the following table:
In comparison, the Australian sharemarket 5-year performance has resembled a yo-yo and is still negative at -4.75% (or about -1.5% if all dividends paid to investors are included):
As things stand though, this performance is unlikely to be repeated going forward, due to the confluence of several events.
Firstly, the ongoing reductions in official interest rates (also known as "financial repression") have meant that more and more investors are looking for yield outside of basic cash investments (i.e. term deposits). This has pushed the trading price of top hybrids substantially in excess of their ‘face value’ and has the effect of decreasing the returns to those investors who are buying at these elevated price levels.
More cash chasing yield has also meant that new issues coming to the market can offer less to investors – a good example here is the recently listed Macquarie Capital Notes (ASX code MQGPA). Where its predecessor, the Macquarie Convertible Preference Shares (MQCPA) carried a fixed coupon (interest rate) of around 11% p.a., the new Notes pay a floating rate which currently equals around 6% p.a.
In most cases, the income distributions are discretionary and non-payment does not constitute default – in other words, these hybrids carry risks comparable to shares, but with no corresponding capital upside.
More importantly though, the recent new issues have introduced additional features, many of which arise as a result of the Basel III international banking agreement.
Without going into too much technical detail, probably the two most important considerations that will affect our future selections in the hybrid space relate to the following:
- No early redemption: Many of the currently listed hybrids have a ‘first call’ date and a ‘maturity date’. Typically the first call can be made within 5 years after listing, while maturity may be in 50 years. In the past, the top hybrids have always been redeemed at the first call date, which allowed us to work within a relatively short to medium-term framework.
While the top hybrids are quite liquid and can be sold on the market at any time, the first call date feature gave us the ability to plan for a retrieval of the full face value within a reasonable time horizon. Going forward, selling at the market – possibly at prices lower than face value – will essentially be the sole way to transact the new hybrid issues.
- Non-viability clause: This gives ASIC the right to call a hybrid issue at any time, if they decree that the issuer has become ‘non-viable’. At that stage, outstanding hybrid issues would typically need to be compulsorily converted to ordinary shares, with the loss in equity value this would entail.
The recent announcement gives no guidance on when a bank is considered to be "non-viable". Whether this would occur at the point that a bank becomes technically insolvent or at some earlier point is unclear.
Any capital instrument issued on or after 1 January 2013 must meet the above criteria if it is to be counted towards Additional Tier I or Tier II capital. Recognition of capital instruments as Additional Tier I or Tier II capital that are issued prior to 1 January 2013, and do not meet the new criteria, will be progressively phased out from 1 January 2013 (even though they meet the other Additional Tier I or Tier II criteria).
We will need to watch the hybrid space with a lot more attention to detail going forward.
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