Hybrids oversold on franking fears

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Some hybrid investors hit the panic button last month, after learning that Labor’s dividend franking policy would the sector, and sold their holdings.

The result was a blowout in hybrid trading margins of as much as 50 basis points. Morningstar analyst John Likos described it as a “swift and savage reaction.”

Now that the dust has settled, analysts are assessing the short-term buying opportunities in the sector and its long-term prospects.

When company issues a hybrid it offers investors a floating rate return expressed as a margin over the bank bill rate. The distributions paid on the popular hybrids issued by the big banks are fully franked.

In the case of the recent Commonwealth Bank issue, PERLS X, the margin was 3.4 per cent over a bill rate of about 1.8 per cent – a yield of 5.2 per cent.

However, the bank will not pay 5.2 per cent. It will pay 3.4 per cent, assuming that investors will bring the return up to 5.2 per cent by claiming the franking credits attached to the distributions.

From a tax point of view, a fully franked yield of 3.4 per cent is a yield of 5.2 per cent on which the company has paid tax of 30 per cent. The hybrid investor can offset the company tax paid against other taxable income, just as they would with dividend income.

Elizabeth Moran, the director education and research at FIIG Securities, says: “The thing you must note with hybrids is that they assume all investors can claim franking and so the stated return also includes it.”

Moran says that if an investor had no capacity to claim franking – for example, a self-funded retiree under Labor’s proposed changes – then the hybrid return would be too low for the risk involved.

Morningstar says that if Labor’s policy goes ahead, some investors stand to lose a significant proportion of their total return on their hybrid investments.

SMSFs would bear the brunt of this policy. Super fund earnings are exempt from tax if they are in pension phase and they qualify for cash rebates on franked dividends.

Its view is that “the removal of the cash rebate for some investors directly impacts the demand curve for additional tier 1 securities (hybrids). This may require issuers to adjust issue sizes, pricing and potentially the market of issuance.”

But in the short-term, Morningstar says the “the recent [hybrid] sell-off has been overdone, presenting attractive opportunities for medium to high-risk investors.”

It has upgraded a number of securities, including ANZ Capital Notes 4.

“However, it should be noted that we have been of the view that [hybrid] securities were expensive prior to the sell-off,” it says.

“Assuming investors can still utilise the full benefit of franking, we believe many AT1 securities now adequately compensate, even under a Labor victory scenario.

“We retain full confidence in the issuers to continue to meet their relevant payment obligations and believe such volatility will once again offer attractive entry points.”

Morningstar says there are several reasons beyond Labor’s policy for the sell-off. Spread widening has also been influenced by a recent increase in issuance, including recent Westpac and Commonwealth Bank issues. The expectation of higher interest rates in the US has had an impact on US dollar-denominated hybrid securities.

DCM Review agrees that the sell-off has created opportunities, not just in the additional tier 1 securities market but also in the broader listed debt securities market, where “securities are largely being priced relative to the AT1 securities.”

DCM says one of the cheapest securities in the market is NAB’s Capital Notes.

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