SMSFundamentals: New High Yield Issues From Westpac And NAB

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

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By Greg Peel

Westpac ((WBC)) has announced a new capital issue available to investors in the form of an equity/fixed income hybrid called Westpac Capital Notes. Broker allocations will commence prior to shareholder notification and a listing of the securities in March, with the ASX code WBCPD.

National Bank ((NAB)) has also announced a new hybrid capital issue, this time called NAB Convertible Preference Shares (CPS), which will also see the same timetable of allocation, notification and a March listing as NABPA. As the following assessment, based on the analysis of self-managed investment specialist Wealth Focus (www.fundsfocus.com.au), attests, these two issues differ in label but differ very little in structure. Hence they are all but identical, and indeed all but identical to the currently listed CommBank ((CBA)) Perls VI (CBAPC), Westpac CPS (WBCPC) and ANZ Bank ((ANZ)) CPS3 (ANZPC).

Hybrid securities have been around for decades but have never found great favour with investors, particularly retail investors. While in theory offering a risk/reward balance through a fixed income stream that can convert into ordinary shares given certain triggers, hybrids have also been issued by banks and other corporates as a means of sneaking around tier one capital regulations or gearing ratio considerations. When the GFC hit, ASIC was already concerned that some securities being offered had become so complex in their structure that few, let alone the humble retail investor, truly understood their pitfalls. Prior to the GFC retail investors were only really interested in equity and not in fixed income but today it’s quite a different picture.

ASIC has since tightened the rules on hybrid complexity, while APRA has tightened its rules on how hybrids are treated with regard to bank tier one capital. Funding available to Australian banks has remained elevated in cost at the same time Australian investors have clamoured for alternative investments to shares, and hence the banks have undergone a term deposit rate war ever since. They have also stepped up their debt instrument issues. While some recent issues have been of the more vanilla corporate bond variety, hybrid issues remain popular with the issuers.

In recent years fixed income analysts have assessed different corporate hybrid issues, bank or otherwise, as anything from a viable high-yield alternative to the underlying shares to “do not touch this thing with a ten foot pole”. The devil is always in the detail, hence analysts are always very quick to insist potential investors understand the instrument and its traps before diving in. This is not to say all hybrids offer traps for the unwary or are not a valuable investment. Interest in Australian hybrid issued picked up towards the end of 2011.

Under upgraded APRA regulations, recent bank hybrid issues have contained “non-viability” and “capital trigger” clauses which ensure that if a bank’s tier one capital ratio falls below 5.125%, or if APRA deems the bank to be unviable without a capital injection, hybrids would automatically convert to ordinary shares. A conversion to shares in lieu of a fixed income stream might be attractive if a bank is outperforming, but a fixed income stream is a far safer option of it appears the bank is struggling. The hybrid investor would clearly be converted into shares falling in price like a stone in this instance.

As Wealth Focus notes, the most recent hybrid issues contain a further trap in the form of an “inability event” clause. In short, if the bank is unable to issue further capital and thus ceases to trade, there is no consideration of where hybrids lie on the ranking ladder. Hybrid investors merely lose their entire investment.

This all sounds very scary. But investors have to consider whether they believe an Australian bank, particularly a “pillar”, would ever get itself into that much trouble (current tier one capital ratios stand at around 7-8%, up from GFC lows) or, more importantly, whether an Australian government would ever let them. We recall the rapid response of the Rudd government to the GFC (eg immediate deposit guarantees to $100,000) and if you really want to stretch the limit, we can look to the US and its bank-rescue TARP.

If you think Aussie banks are as a safe as… well, a bank… then there may be little need to fear the unlikely triggering of these clauses. However, they are still part of the instruments’ conditions and cannot be ignored. At the very least, suggests Wealth Focus, such clauses should imply a higher risk premium (coupon) be paid to the investor.

The WBCPD was flagged by the bank of paying a coupon of 3.2% to 3.4% per annum (paid quarterly) over the 90-day bank bill swap rate (BBSW) which on February 14 was 3.03%. This implied a potential coupon of 6.23-6.43% but the final price would come down to demand. The first call date is in March 2019 and the scheduled conversion date is March 2021. The notes have since been allocated, and the issue extended to $1.5bn from an advertised $500m due to strong demand, which has also ensured a low-end 3.2% premium. One must ask whether advertising a certain size of issue and then tripling it after allocation is fair play to early investors who will be effectively diluted by the security’s greater availability to all investors.

Wealth Focus points out that one can compare the 3.20% premium in the WBCPD to the previously listed WBCPC which offers a 3.36%pa premium (at the time of writing) and can be bought on the ASX, or to the CBAPC which offers 3.23% and is CBA, not Westpac (CBA is considered “safer” by analysts). In other words, if you’re worried you might miss out, you haven’t. Oh and neither of the earlier issues include an “inability event” clause.

Like the WBCPD, the NABPA will offer a 3.2-3.4% premium range over 90-day BBSW and a first call date in March 2019.

Unlike the WBCPD, there is no earlier NAB issue with which to compare. And as NAB has not been a big issuer of hybrids, Wealth Focus sees a certain attraction to investors based on portfolio diversification amongst bank investments. However, one might note that while Westpac may not be CBA, NAB is not at all Westpac. NAB is a lot smaller.

Despite the questions raised above, Wealth Focus believes, as many would, that Westpac and NAB will be swamped with applications given the considerable thirst for alternative investments in the longer term investor marketplace. Particularly the self-managed. Potential investors may be interested to know, nevertheless, that ANZ has just dropped a major hybrid bombshell in deciding not to call an earlier listed hybrid security when all and sundry expected it would.

An ANZ tier one hybrid note issued in New Zealand in 2008 was sold on the basis of a first call in April this year. The first call is the first opportunity for the issuer to trigger conversion of the hybrids into ordinary shares. To date it has almost been considered impossible for a pillar bank not to call a hybrid at first opportunity given the loss of respect from the investment community (irrespective of the bank’s right not to as per the original conditions).

The result is that instead of ordinary shares, next month holders of ANZ’s hybrid will continue to receive a coupon based on a premium over the five-year swap rate (NZ). That swap rate will reset to around 5.5% from the 9.66% set at listing in 2008, which is not inspiring.

Regional banks and some corporates have previously failed to call hybrid issues, but ANZ’s actions represent a first for a pillar bank. The question must thus be as to whether a precedent has now been set.

All of the above might suggests SMSFs simply give hybrids a wide berth no matter who the issuer. This is not the case. In recent years, various hybrid issues have been welcomed by analysts as a sound investment and worthy of portfolio inclusion. The bottom line is those investors interested in hybrids or any other form of fixed interest security are strongly advised to seek an independent opinion from a specialist before rushing into an investment with only percentage-of-yield signs in their eyes.

A financial advisor is a good place to start but may not, by any means, be an expert in complex fixed income, while if your broker is keen to set you from an allocation, beware that they need to shift their inventory.
 

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