Your bank hybrids are junk

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Suncorp Group completed an issue of additional tier one capital notes, more commonly known as hybrids, last month, after receiving strong retail investor demand for the securities. It will pay investors a regular distribution set at the bank bill rate plus a margin, which at the time of issue was 4.08 per cent fully franked.

Hybrids are issued with a number of conditions, such as a conversion to equity in certain conditions, which mean investors should demand a premium rate. A little over four per cent fully franked might seem like a good premium over rates offered on other deposits and fixed income securities but some commentators have long argued that investors are not getting enough of a premium for the risk they take.

To put it in context, over the past five years Suncorp’s dividend payouts have represented yields of between 4.6 per cent and 5.7 per cent fully franked. Hybrids have some equity-like characteristics, so (the argument goes) why not buy the shares and enjoy the upside on the share price as well as a higher yield?

This question has come into sharper focus since Standard & Poor’s announced last month that it was cutting the stand-alone credit profiles of the four major banks, along with the SACPs of most other financial institutions.

The major banks are the biggest issuers of hybrid securities in the Australian market and ratings on those securities have fallen from BBB to BB+, which means they are no longer investment grade.

To be clear about S&P’s move, it affirmed the issuer credit ratings on the four major banks, reflecting its expectation of likely timely financial support from the Australian government.

However, to reflect its view of increased risk in the Australian economy it lowered its assessment of the SACPs of almost all financial institutions operating in Australia, including the majors.

And it lowered its long-term issuer credit ratings of 23 financial institutions in Australia by one notch each.

The SACP is S&P’s opinion of an issuer’s creditworthiness in the absence of extraordinary support. It incorporates direct support already committed and the influence of ongoing interactions with the issuer’s group or government.

The SACP differs from the issuer credit rating in that it does not include potential future extraordinary support from a group or government during a period of credit stress for the issuer, expect if that support is system wide.

S&P does not expect the government to support hybrid security holders if a big bank gets into trouble. As a result of the change to SACP, ratings on the big banks’ hybrid securities and subordinated debt were lowered one notch.

Westpac confirmed this when it issued a statement saying S&P’s credit ratings on its outstanding additional tier one capital and tier two capital instruments have been reduced by one notch to BB+. The other big banks made similar announcements.

Specialist fixed income broker FIIG Securities posted an article on its website last week, saying investors should take note and reassess current portfolio allocations and returns.

FIIG says investors should ask themselves whether they are comfortable with the risk in bank hybrids, whether they are being paid enough and whether their portfolios are sufficiently diversified to bear the risk.

“In theory, the cost of issuing new hybrids has just gone up. We would usually expect to see some downward pressure on prices for existing securities but the large number of retail investors looking for income means hybrids may well continue to find support,” FIIG says.

“At FIIG we do not trade in listed hybrid securities, as we consider they are not fixed income and do not provide the protections offered by bonds and other fixed income securities.”

The newsletter Yield Report points out that the mandates of some investment funds prohibit them from holding sub-investment grade securities. These funds would need to dispose of holdings in breach of their mandates. However, it also points out that the bulk of hybrids is held by retail investors.

“How these disposals affect yields will depend on the rate at which they occur and the liquidity of the relevant securities,” Yield Report says.

So what are the equity-like characteristics of hybrids that add risk for retail investors? They are subject to non-viability triggers, which means that if the Australian Prudential Regulation Authority determines that a trigger event occurs the notes will be converted to ordinary shares or written off.

Trigger events are designed to give hybrids a loss absorption capacity in conditions of financial stress. They include serious impairments and insolvency.

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