September 2012
Hybrids and Subordinated Debt
In this paper we will look at what is driving the
flood of new hybrid issues in 2012 and discuss
why no two hybrid issues are the same. There
are a large number of different combinations of
terms and conditions hidden in the fine print.
Ashley Owen, CFA
Chairman of the Centric Wealth
Portfolio Construction Committee
The Ideal Capital Structure of a Company
The operations of companies are financed by a
combination of equity, debt and also by funds raised using
“hybrid” instruments. Hybrids are securities with some of
the characteristics of both debt and equity. This mix of
debt and equity that supports a company’s operations is
known as its capital structure.
Capital structures vary across industries, company sizes
and market conditions. There is no single ideal capital
structure. A capital structure that may be appropriate for a
company like Sydney Airport would almost certainly result
in insolvency for a company like Alumina. Companies
with relatively certain cash flows to service their loan
commitments, such as regulated utilities, can generally
support a relatively high level of debt. Conversely, a junior
gold explorer or freshly minted internet company will
almost always be totally equity financed. Their lack of
incoming cash, or more accurately monthly cash burn,
makes it difficult to meet incoming interest payments or
even convince a bank to lend.
Risk / Reward Scale
There are various layers found in the capital structure
of many companies. The layers include ordinary equity
and different types of debt and hybrid instruments and
are ranked by the relative seniority of their claims on a
company’s cash flows and assets. The securities with the
lowest risk generally receive the lowest potential returns.
As investors travel up the risk/reward scale, they are
exposed to greater uncertainty as to their returns and thus
demand higher returns as compensation for the increased
risk.
Buying debt instruments like deposits, bonds, notes or
hybrids makes you a creditor or lender to a company.
Before lending money to a company, it is important to
know who is standing in front of you in the queue to get
their hands on the company’s cash flows and assets.
Starting at the front of the queue, with the lowest risk/
return layer of funding in the capital structure of a bank:
• C
ash and Term Deposits: The borrower (in this case
a bank) is liable to pay the lender (depositor) nondiscretionary interest payments (ie the borrower has
a contractual obligation to make the payments) for a
fixed term, and the return of their principal is backed
by a Commonwealth Government Guarantee up to the
first $250,000 per institution, per entity where eligible.
• C
overed Bonds and Residential Mortgage
Backed Securities (RMBS): With these instruments
the investor is entitled to non-discretionary interest
payments for a fixed term. The return of their principal
is generally secured by specific assets, usually a pool
of residential mortgages. Covered bonds also provide
investors with recourse on an unsecured basis to
the issuer’s non-pool assets should the pool prove
deficient.
2
Centric Wealth Investment Insights
• S
ecured Debt: The investor receives non-discretionary
interest payments for a fixed term. Unlike covered
bonds and RMBS, the return of their principal is not
secured by any specific assets, but rather by a fixed or
floating charge over the assets of the borrower.
• S
enior Unsecured Debt: The lender (investor) receives
non-discretionary interest payments for a fixed term,
but the return of their principal is not secured by any
assets, and these bonds are “junior” to (or rank lower
than) any secured claims in the event of default. The
interest rate is higher on senior unsecured debt than
on secured debt because the best assets are already
pledged to the secured creditors who get paid first.
• S
ubordinated Debt: This has similar features to senior
unsecured debt, but ranks behind the senior debt (and
is paid out after senior creditors), and therefore requires
a higher interest rate to compensate for the higher risk.
• H
ybrids (Convertible Preference Shares): These
securities pay dividends that are generally franked,
but the payments may be at the discretion of the
issuer. The term of the issue may be fixed or perpetual,
and the issuer may have the option to redeem the
unsecured principal for cash or company shares.
No two hybrid issues are the same. There are a
large number of different combinations of terms and
conditions hidden in the fine print and the assessment
of the relative risk of each issue is quite complex.
• O
rdinary Equity: Ordinary shareholders bear the
highest risk but also have the opportunity of the
greatest upside potential. Ordinary shares have
no maturity date, and the distributions (dividends)
may grow or shrink along with the profitability of the
company over time. In the event of a winding up of
the company, the ordinary shareholders are right at
the back of the queue and only receive a share of the
proceeds after all of the other higher ranking claimants
are paid in full. As a result of these conditions, the
required rate of return on equity should always be well
above that demanded for either secured debt or term
deposits.
The flood of debt and hybrid issuance in 2012
So far 2012 has delivered a vintage year for IPOs in
the hybrids and subordinated debt markets, with new
issues hitting the market virtually every week. For 2012
until September issuance has already been $10.4 billion,
which is well in excess of the $3.4 billion raised in 2011.
Current indications suggest 2012 may well top $12 billion
in new issues.
Debt and Hybrid Issuance $Billion
per calendar year
$12.0
$10.0
$6.0
$4.0
$0.0
2007
2008
2009
2010
2011
2012*
Source: UBS, Philo Capital Advisers
*to September 2012
Debt and Hybrid Issuance deals completed
per calendar year
10
8
6
4
2
0
2007
2008
2009
Source: UBS, Philo Capital Advisers
*to September 2012
3
One of the key reasons driving hybrid issuance is that
in the wake of the Global Financial Crisis (GFC) there
are now fewer banks to approach for funding. Whilst
overall corporate balance sheet leverage in Australia is
at historically low levels, companies continue to face
funding pressures to finance their expansion plans.
Ongoing global uncertainties, particularly in relation to
the European debt crisis, have kept wholesale funding
markets in a state of risk aversion.
Ratings Agencies Tightening Standards post the GFC
$2.0
12
Alternatives to the Banks
Bank balance sheets are contracting across the globe
as they attempt to comply with the tighter regulatory
standards that are being imposed over the next year.
These tighter standards on capital adequacy, liquidity and
stress testing have seen global banks selling or closing
operations to raise capital.
$8.0
14
Why are Companies Issuing Hybrids
now?
Centric Wealth Investment Insights
2010
2011
2012*
Another factor driving the high levels of hybrids issuance
has been the pressure being applied by rating agencies,
such as S&P and Moody’s, to companies to strengthen
their balance sheets in order to remain “investment
grade”. The GFC was not kind to the reputations of the
major credit ratings agencies. In an attempt to rehabilitate
their image, credit ratings agencies are now tightening
their scoring processes to more conservative settings.
Consequently the ratings agencies are encouraging
corporates to raise hybrid debt that can be converted into
equity during times of financial stress.
Understandably global banks have experienced the
highest level of negative revisions to credit ratings, and
a lower credit rating will generally result in a high cost
of funding. One opportunity for a company to boost its
credit rating is to issue subordinated and hybrid capital.
These debt instruments rank behind senior debt, and
thus in effect provide a buffer for the senior lenders,
depositors and taxpayers in the event of insolvency.
Credit ratings agencies recognise this additional layer of
capital by providing a so called ‘equity credit’. This credit
feeds into the scoring framework the agencies use to
determine if a company is a BBB- or AA for example. This
will then have an influence on the interest rate a company
pays on its senior debt.
Centric Wealth Investment Insights
3
ASIC Making issuing to the Retail Market Easier
But the Devil is in the Detail!
Changes to regulations over the past 18 months have
made it easier for companies to issue hybrids to retail
investors. The financial sector has been quick to seize
the opportunity. The banks account for 60% of the
total subordinated note issuance this year. Non-bank
corporates like Tabcorp have also sought to issue senior
bonds and more are in the pipeline. As corporates
continue to seek to diversify funding sources, appetite for
accessing the retail market for funds will likely continue.
The old adage for hybrids is that they have “all the upside
of bonds, with the downside of equities”. After looking
through the range of conditions contained in the issues
that we have seen in 2012, we would see it as a mistake
to view hybrids and subordinated debt as a substitute for
cash in a portfolio. Whilst the headline rates often look
very attractive in the current environment of declining term
deposit rates, these instruments should not be viewed
as cash as the terms and conditions are rarely written to
work in the favour of the investor. Investors need to be
compensated adequately for the extra risk they are
taking on with each layer in the capital structure.
Protect the Taxpayer
During the GFC, taxpayers across the globe were forced
to provide funds to bail out companies from carmakers
to insurance companies and banks. As a reaction to
the politically unpalatable images of executives arriving
in private jets with their hands out, we have seen a
tightening of capital requirements which has stimulated
the issuance of hybrid securities with fewer investor
protections and structured increasingly like equity.
Investors receptive: The Chase for Yield
Whilst companies may wish to issue listed credit to retail
investors, the other part of the equation has been strong
retail demand in 2012 for these instruments. Falling cash
and term deposit rates this year have resulted in listed
income securities appearing more attractive to investors
seeking yield, particularly in the retirement income
segment where investors may rely on the income derived
from their investment portfolios.
Unlike term deposits investors in listed credit instruments
typically face the following conditions:
• R
edemption clauses: Redemption is where the
issuer provides a return of principal at a future date.
Subordinate debt and hybrid securities often have
clauses which may delay the return of an investor’s
funds. One recently issued subordinated note allowed
maturity to be extended from 2018 to 2038 without
increasing the margin paid and provided holders with
no right to request an early redemption.
• S
ecurity: In the event of insolvency most hybrids
will only rank ahead of shareholders and behind all
other liability holders. Investors can also experience
a mandatory conversion of their hybrids which may
result in a converted value materially less than the
original principal value.
The following is a table provided by Westpac to describe
the layers in its capital structure:
High ranking
Illustrative example
Preferred and secured debt
Liabilities in Australia in relation to protected accounts (generally, savings
accounts and term deposits) and other liabilities preferred by law
including employee entitlements and secured creditors
Unsubordinated unsecured
debt
Trade and general creditors, bonds, notes and debentures (including
covered bonds) and other unsubordinated unsecured debt obligations
Subordinated unsecured debt
Westpac Subordinated Notes and other subordinated bonds, notes and
debentures and other subordinated unsecured debt obligations with a
fixed maturity date
Subordinated perpetual debt
Subordinated perpetual floating rate notes issued in 1986
Preference securities
Westpac Hybrids (Westpac TPS 2003, Westpac TPS 2004, Westpac
TPS, Westpac SPS, Westpac SPS II, and Westpac CPS)
Ordinary shares
Westpac Ordinary Shares
Lower ranking
4
Centric Wealth Investment Insights
How we assess risk and return
• L
iquidity issues: Historically liquidity has been an issue
with the majority of hybrids issues, meaning that it is
often difficult to sell securities on the market without
affecting the price. Most hybrids are traded only thinly,
making it often difficult to find buyers, especially in a
panic.
When we analyse a hybrid security, we assess where
they sit against the range of other instruments issued
by an institution to check whether an investor is being
adequately compensated for the risk that they are taking
on. The next chart shows both the current rates and ideal
rates on various layers of the capital structures of the four
big banks in Australia.
• P
rice Volatility: One aspect of risk is price volatility.
When looking at the different layers of bank funding,
at one extreme the value of a term deposit remains
constant, while at the other extreme the bank share
prices are volatile. The prices of the various layers of
the capital structure in between these two extremes
also vary considerably. The lower down the priority
ranking, generally the higher the price volatility of the
security.
We begin with the risk-free RBA target cash rate (currently
at 3.5%) and then we assign a spread above bank bill
yields that is necessary to compensate an investor for
each additional layer of risk they take (each person in front
of them in the queue to get their hands on the company’s
cash flow and assets), all the way up to ordinary shares
which sit at the back of the queue.
10%
9.70%
1,300
Current yields
Fair value spread over Cash Target
1,100
Current spread over Cash Target
7.20%
Current spread surplus/shortfall
Fair value Yield (gross)
Current Yield (gross)
6.45%
620
450
700
+170
500
300
100
+10
115
5
+10
-10
-5
-50
-20
-20
0%
4.95%
295
285
4.65%
3.45%
+0
+0
0
0
2%
3.30%
3.55%
145
135
3.50%
145
+195
3.00%
3.30%
125
3.50%
4%
900
4.85%
370
325
4.75%
6.75%
6.35%
-10
4.95%
8.00%
-100
-45
8%
6%
1,500
Yields and Spreads across Capital Structure
Spreads over Cash Target Rate September 2012
-2%
-300
+195
Term Deposits
(<1y)
+0
RBA Cash
Target rate
+0
3m T-Bills
+10
Bank Bills
+10
Covered Bonds
-10
Senior
Unsecured
Debt
-10
Subordinated
debt
-45
Hybrids (CPS)
+170
Ordinary Shares
Higher Risk
The purple line on the chart shows the rate of return (either
interest or dividends) that provides a minimum acceptable
return for each level of risk. The required return rises, as
the risk rises from left to right through the various layers of
the capital structure. The blue line shows the level of rates
based on the current market.
At current prices we view the major trading banks ordinary
shares (on the far right of the chart, with the most risk)
and short-dated term deposits (on the far left, with the
least risk) as being cheap at the moment relative to their
respective risk. This means that shares and term deposits
currently offer rates that more than compensate holders
for the relative level of risk.
5
Centric Wealth Investment Insights
By comparison, hybrids, subordinated debt and covered
bonds are historically relatively expensive for their
respective risks, meaning that the current level of returns
do not adequately compensate holders for the level of
risk they bear. In particular we see that bank hybrids,
which are currently trading at an average spread over
bank bills of 3.2%, are very expensive on a risk-adjusted
basis. Accordingly in our recommended portfolio for listed
interest rate securities, we are heavily weighted in favour of
the more secure subordinated debt issues.
Centric Wealth Investment Insights
5
How real are the risks?
The current situation
The holders of the most junior layers of debt – hybrids,
and then subordinated debt - will be the first and second
ports of call to bear losses if and when issuers get into
trouble. The new bank hybrid issues being offered by
Australian banks are specifically designed to be available
to be converted into equity at the first sign of stress in the
bank.
At the moment ordinary shareholders in the big-4
Australian banks are getting grossed up yields of around
9.7% on bank dividends. They also have the upside
potential of share price growth if the bank prospers and
grows, but they also have downside risk of loss if the bank
fails.
The GFC saw hundreds of banks being rescued by
governments (tax-payers), but tax-payer patience for more
bail-outs is nearing its limits. There is increasing pressure,
globally and in Australia, for private lenders (including
hybrid and subordinated debt holders) to bear some of
the losses for bank failures, instead of endless tax-payer
funded bail-outs. For example, the holders of Irish bank
hybrids lost 80% of their money in the Irish banking
crisis last year, and the holders of Spanish bank hybrids
(which are also mostly retail “mums & dads”) are looking
increasing like being forced to bear some of the losses in
the impending Spanish bank crisis.
Although Australian banks appear well capitalised, they
are very heavily reliant on foreign debt markets for their
funding, and their desperation to reduce their reliance on
foreign debt can be seen in the very high interest rates
they are to paying on term deposits in order to attract
local Australian depositors.
The risk of failure of Australian banks is very low, but
holders of debt instruments that are also very low down
in the pecking order (hybrids and subordinated debt)
need to be adequately compensated for the risks they are
taking on. Under the new capital rules known as Basel
III, the lower ranking layers of debt are there specifically
to provide a buffer zone that can be sacrificed in order to
protect the higher ranking creditors and keep the banks
solvent in the next crisis.
6
Centric Wealth Investment Insights
Hybrid holders on the other hand are receiving yields of
around 6% to 7%, which is significantly less than ordinary
dividends, but they bear almost the same risk. In the
situation where the bank gets into trouble, these hybrids
will be converted into equity in a failing bank. On the other
hand if the bank does well, hybrid owners have limited
upside returns and don’t get to benefit of any share price
growth. Hence the expression that hybrids have “the
upside of debt, but all the downside of equity”.
These are real risks. Banks (including Australian banks) are
highly geared. It only takes a decline in asset values of a
few per cent to wipe out the equity in a bank, rendering it
insolvent. Westpac came very close to collapse only 20
years ago in the last Australian property & banking crisis in
the 1990-1 recession (and ANZ was not far behind it).
If such a crisis were to occur again, the government
guarantee only applies to bank deposits, and it will be the
hybrid owners who will be the first to bear losses, followed
by subordinated debt holders. Consequently they need
to receive much higher interest rates than the more senior
and secured layers in the capital structure. In fact, the new
hybrid issues like CBA’s PERLS VI have been specifically
designed to bear losses in order to protect more senior
creditors standing in front of them in the queue; so that
the bank has better chance of surviving.
Hybrids are the “crash test dummies” or the “crumple
zones” in the bank capital structure. They have been
designed to be sacrificed so that the senior creditors
(especially the depositors) and tax-payers are spared
from loss in the next crisis.
Summary
Protecting investors’ capital in good times is relatively
straight forward – by avoiding operations like Madoff,
Basis Capital, Storm Financial, Australian Capital
Reserve, Westpoint, Opes Prime, Chartwell, Trio, etc.
etc. Protecting investors’ capital for times of crisis is
much more difficult and requires in depth analysis and
understanding of the risks hidden in the capital structure
of the issuing company and lurking in the fine print of
the complex documentation that accompanies these
securities.
The biggest issuers of lower ranking debt in recent times
have been the big banks, as a direct result of the global
banking crisis that is still only part-way through, and in
which they are inexorably interlinked.
It is a mistake to think that, just because the local banks
appear safe, every layer of debt in their complex capital
structures have equal risk/reward characteristics. It is also
a mistake to view hybrids and subordinated debt issues
as the equivalent of cash except with higher interest rates.
We see that as long as the risks are understood and
correctly priced, there are opportunities for investors.
In investing there are many traps for the unwary. We
are dedicated to finding the best opportunities while
protecting capital and preserving real wealth for investors.
Over the past year as the flood of new hybrids have been
issued, we have sought to be very prudent in selecting
only those securities that match our selection criteria.
You can see from the graph below that we filter out the
majority of hybrids that come to market. Of those that
remain less than 1 in 3 securities are accepted after being
reviewed. Of the securities we do approve, there is also
discipline required to sell them when they reach our target
price and replace them with more fairly valued securities
where exposure is warranted in a client’s portfolio. We are
pleased that the securities we have added to our preferred
portfolio of hybrids this year have each added value. Since
inception in September 2010, the Centric “Core Interest
Rate Securities Portfolio” has achieved returns after costs
that are +1.8% ahead of the benchmark for the sector.
APPROVED
Woolworths Notes
II, AFIC Notes, ANZ
Notes, NAB Notes,
Westpac Notes
~1 in 3 acceptance rate
from those securities that
pass our initial review
RESEARCHED BUT NOT APPROVED
AGL Energy Notes, Colonial Notes,
Healthscope Notes, Origin Energy
Notes. Tabcorp Notes, ANZ Pref Shares,
Westpac Pref Shares
FAILED INVESTMENT GRADE SCREENING
Receivables CDO’s, structured finance products, CMBS issues,
mezzanine debt issues, micro finance loans
Scan the QR code to
download this report
7
Centric Wealth Investment Insights
Centric Wealth Investment Insights
7
Financial security and confidence
Providing you with the specialist advice you need.
Centric Wealth understands the complexities of your finances and
that your financial goals and needs are ever evolving.
We work with you to gain financial security by implementing
solutions that consider your existing investments, financial goals
and risk appetite in conjunction with your personal finances.
Our dedicated research and investment team provide a dynamic
investment process that is tailored to your needs and goals.
Financial Planning I Risk Insurance I Lending Services I Corporate Benefits
Centric Wealth Advisers Ltd ABN 88 090 684 521 AFSL 243253, Centric Lending Services Pty Ltd Australian Credit Licence No. 392142
Contact us
Sydney
Melbourne
Brisbane
Canberra
Level 9
60 Castlereagh Street
Sydney NSW 2000
Ph: 02 9250 6500
Fax: 02 9250 2702
Level 14P
530 Collins Street
Melbourne VIC 3000
Ph: 03 8639 1300
Fax: 03 9654 9502
Level 8
120 Edward Street
Brisbane QLD 4000
Ph: 07 3230 6555
Fax: 07 3221 2145
Mezzanine Level
55 Wentworth Avenue
Kingston ACT 2604
Ph: 02 6281 1477
Fax: 02 6281 1476
www.centricwealth.com.au
[email protected]
Produced
in conjunction with
This article has been prepared for clients of Centric Wealth Advisers Limited ABN 88 090 684 521 AFSL No. 243253 (Centric Wealth) by Philo Portfolios Pty Ltd ABN 87 154 859 266
authorised representative no 416314 of Centric Wealth. The article is based upon generally available information and is not intended to be, or to replace specialist advice in the areas
covered but rather, the article is intended to be informative and educational only. Although the information is derived from sources considered and believed to be reliable and accurate,
Centric Wealth, its employees, consultants, advisers and officers to the maximum extent permitted by the law disclaim all liability and responsibility for any opinion expressed or for any
error or omission that may have occurred in this document. This article may contain ‘general advice’ which is defined in the Corporations Act to mean that we have not taken into account
any of your personal circumstances, needs or objectives. It is therefore imperative that you determine, before you proceed with any investment or enter into any transactions, whether the
investment or transaction is suitable for you in consideration of your objectives, financial situation or needs and you must therefore, before acting on any information included in this article,
consider the appropriateness of the information having regard to your personal situation. Centric Wealth recommends that you obtain financial and tax or accounting advice based on your
personal situation before making an investment decision.