Traps behind the hybrid issue offers from the banks

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This was published 7 years ago

Traps behind the hybrid issue offers from the banks

By Marcus Padley

The NAB has announced a $750 million hybrid issue and Westpac has announced a $1.45 billion hybrid issue. This follows three recent issues from the Commonwealth Bank, Macquarie and AMP, all of which are trading at a premium to the $100 issue price. The hybrid appetite has returned. The Westpac issue, for instance, was a $750 million issue but the book closed early and they took in $1.45 billion, almost double the offering. The NAB issue announced this week is also $750 million but if it follows the Westpac trend it will go to at least a billion if not more.

Hybrids are sold on the illusion of a "risk free" yield. The Westpac notes have a 6.9 per cent yield, for instance, and that's all people care to know. The fact that it is a fully paid, non-cumulative, convertible, transferable, redeemable, subordinated, perpetual, unsecured note that yields 6.9 per cent is an inconvenience that no one dares to question, and that's the Achilles heel. No one really understands them.

Buying hybrid issues in the big banks might mean you miss out on buying regular bank shares while they're cheap.

Buying hybrid issues in the big banks might mean you miss out on buying regular bank shares while they're cheap.Credit: Karl Hilzinger

The hybrid selling point and the reason people feel "duped" by earlier issues is that on the face of it, to an equity investor, they look like a risk-free bond. They obviously aren't risk free and the "perpetual" nature of some hybrids means there is no yield to maturity, no guarantee of getting your dollar back and, on that basis, they can trade at a significant discount to the issue price "in perpetuity" as well.

The Westpac and NAB issues will attract about $3 billion of funds and some of that money will doubtless be raised by ordinary shareholders switching from the shares to the hybrids, especially if they are only in the shares for income. Thanks to the long-term, set-and-forget nature of hybrids that money is unlikely to find its way back into the equity market any time soon. It's not good for the share prices of the banks, in other words.

Brokers will not resist the switch because they will make a motza on the listing fees of the capital notes and make a motza again selling the ordinary shares for you. So expect every broker and his dog to be suggesting the switch. Hybrid issues are a bonanza for brokers because it offers easy commission in large, liquid well-held stocks and because almost every broker will be trying to flog the notes and get their stamping fee, no one is going to write anything negative while they do.

Of course, the standard hybrid sceptic argument is that the risk on a hybrid is significantly higher than "risk free" because it includes an element of equity risk that pure bond investors would baulk at, but most equity investors don't seem to understand or care about it. All they see is a 6.9 per cent yield being paid by a company that won't go bust.

Where it can all go wrong is in the long-term when there is a disturbance in the force. If interest rates go to zero this will be expensive debt for the banks and they will no longer want to/be able to pay 4.9 per cent over swap, so they will use their small print to refinance and cancel them, most probably to your cost. As a perpetual note there is also no guarantee of getting your money back and, notably, the new NAB and Westpac issues are both perpetual.

And just when you thought it was safe to buy hybrids again, the real risk comes if we experience a second global financial crisis. In a GFC the hybrid share prices will hold and hold compared with the ordinary shares, but if the pressure gets too much, and confidence in the issuing entity is lost, they can eventually collapse. In the last GFC this was apparent in the AMP and Macquarie notes. As it was, this was a great buying opportunity, but not before holders were put through the wringer.

But all this is low odds. The likelihood is that you will get your 4.9 per cent plus swap rate yield, undisturbed by seismic events, and the NAB and Westpac won't go bust.

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Other points to note, and some of the lessons of the last hybrid bubble and the last GFC, include these nuggets of hybrid wisdom.

  • Stick to the big bank issues. Don't go down the quality curve for a higher yield, the risk rises exponentially but the yield does not as the issuing companies get smaller.
  • Avoid perpetual notes. With no guarantee of your dollar back a lot can go wrong and the notes can drop permanently below the issue price.
  • These new hybrid issues are not good news for the existing hybrid issues, which may see some selling as investors rotate into the new hybrids.
  • But the main issue is that the market always bites you back and probably the biggest mistake you'll make switching from banks to hybrids is that you miss out on a fortune by selling banks, they're historically cheap, not expensive after the recent sell-off and they yield more. But you won't know that until later.

Other than that, I'm sure you'll be fine.

Marcus Padley is a stockbroker with MTIS Pty Ltd and the author of the daily share market newsletter Marcus Today. For a free trial of the Marcus Today newsletter please go to marcustoday.com.au.

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