Fixed Income

Is it time to buy hybrids?

While it hasn’t received the same media attention as the recent decline in equities in 2016, significant falls in hybrid prices have also been apparent. As a result the hybrid market has become significantly cheaper, prompting Stuart Gray, Fund Manager, Fixed Income & Head of Credit Research, to question – is it time to buy hybrids?

15/02/2016

Stuart Gray

Stuart Gray

Fund Manager, Fixed Income and Head of Credit Research

The media has devoted numerous headlines to describe the recent decline in equities in 2016. With the local ASX200 index off as much as 8% year to date and down close to 20% since the peak in 2015 investors are increasingly nervous. While it hasn’t received the same media attention, significant falls in hybrid prices have also been apparent. As a result the hybrid market has become significantly cheaper and in the middle of this the CBA has launched their latest hybrid, Perls8, prompting many to question – is it time to buy hybrids?

The Schroder Credit Securities Fund has been a long time investor in the hybrid market but over the past few years we have found more reasons to not invest than we have to invest. Our reasons have centred around two key areas:

  1. Changes in hybrid structures have pushed the securities to be more like equity instruments and less like debt.
  2. The increased risk was not matched by an increase in return, with credit spreads not meeting our valuation targets.

Without sufficient return to compensate for the added risk we didn’t invest in most of the new issues.

One of the drivers of change in the structure of bank hybrids has been regulatory. Bank regulators and governments were determined that taxpayers would not foot the bill for bank failures in the future. As a result bank hybrids in Australia were required to have a clause that allows the regulator (APRA) to declare a bank as not being viable. The point of non-viability (PONV) clause began appearing in hybrid structures in 2013 and it refers to a situation where a bank is under serious financial stress due to insufficient liquidity, capital or both. In practice though, the PONV definition is unclear and in practice its application is untested. From an investors perspective bank hybrids have now been deliberately structured to be loss absorbing capital in the event of a bank reaching a “point of non-viability”. APRA has made clear that in the next financial crisis rather than the banks being bailed out by the government, the investors, and in particular subordinated investors (i.e. hybrid investors), will incur hefty losses to share the pain. As part of our due diligence on PONV securities, when they were first introduced, we investigated a number of valuation methods that, at the time, all concluded the securities were too expensive.

The chart below shows the total return performance for the CBA Perls 7 since issue against both CBA equity and the local bond index. In that time investors would have been better off in CBA equity from a total return perspective, highlighting how hybrids can behave more like equity than debt. Now that the hybrid has sold off, the grossed up yield matches the dividend yield from the shares.

 

Source: Bloomberg, Schroder’s. This is for illustrative purposes only and is not a recommendation to buy or sell.

 

Source: Bloomberg, Schroder’s

The rest of the major bank hybrids have performed in a similar fashion. The chart below shows the issue and current credit spreads for all the PONV Tier1 securities issued by the Australian major banks between March 2013 and September 2015. All are trading wider than the marketing range for the Perls8 deal (525bp – 535bp) and all are wide of their issue spread and below their $100 issue price. For the first time these securities are hitting the value requirements we set in May 2014.

 

Source: Evans & Partners, 15 February 2016. This is for illustrative purposes only and is not a recommendation to buy or sell.

One of the risks in hybrid securities are they are highly structured securities. Any investment requires due diligence on the risks in the structure. In the January 2013 paper The evolution of hybrid securities: Has the leopard changed its spots? we highlighted a couple of risks in the recently issued Crown hybrid. The two key risks centred on:

  1. The only incentive for the issuer to call the security is because they no longer add to equity in the Rating Agency calculations.
  2. Coupons can, and in some cases must, be deferred while equity can continue to receive dividends.

These structural risks have become very real for investors with James Packer rumoured to be planning to take Crown private. For an example of what a hybrid price looks like when it isn’t called and coupons aren’t being paid investors can look to the PaperlinX hybrid. I’m not suggesting that a privatised Crown would treat investors like PaperlinX hybrid investors but under the issue structure they can and the increased risk of the security remaining on issue for 60 years is starting to be reflected in the price.

 

Source: Bloomberg. This is for illustrative purposes only and is not a recommendation to buy or sell.

Conclusion

Value has started to reappear in the hybrid space making hybrids a more attractive investment; however we provide our usual cautions when it comes to investing in hybrids:

  • Hybrids should not be a large proportion of a fixed income portfolio. As we have shown, their performance can be closer to equities and in some cases more volatile.
  • Understand the structure. As painful as it might be you need to read and more importantly understand the structure of each hybrid you own.
  • Valuation is important. Are you being paid for the risks in the structure?

In the Schroder Credit Securities Fund we did not buy any of the PONV compliant bank hybrids because the value didn’t match the risk. We determined a fair valuation and now that the securities are hitting those valuations we are buying a small amount for the portfolio. Liquidity in these securities is poor and supply of new deals will be ongoing and growing so the position size needs to reflect these factors. As for the Crown hybrid we have not bought this security. Risks are still skewed to the downside in the event of the company being taken private. Relying on the interests of hybrid holders to be placed ahead of equity holders requires a little more faith than we are prepared to have.

Related article The Fix: Developments in the hybrid securities market and the broader impact on credit investors

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