Comment: Know your hybrids

Philip Bayley
The recent sell-off of hybrid notes listed on the ASX has seen the market price of a number of notes fall below face value. Typically, these notes have a face value of A$100 but a number are now trading around A$98 or less.

Brokers specialising in this sector have become very excited and have been promoting the affected notes to retail investors on the basis that the price falls present an opportunity to gain a higher yield to call than what was available only a month ago.

With the sale of the Commonwealth Bank's PERLS VII hybrids just last month, the bookbuild for the issue set a record low margin for the calculation of dividend payments. The margin was set at just 280 basis points over the 90 day bank bill rate.

Now the PERLS VII hybrid is trading at A$97.45, offering investors a margin of 330 bps. This is not as good as the margin set on the PERLS VI, which was set at 380 bps but it is certainly better than the 100 bps reduction that was offered to the PERLS VII investors who bought into the issue.

But before investors go looking for the "bargains" now on offer among listed hybrid notes, it is worth being aware that not all hybrids are the same. There are some important differences among hybrids that can significantly alter the return that may eventually be earned.

Bendigo and Adelaide Bank (BEN) provides a good example of the spectrum of different hybrid securities listed on the ASX. BEN also provides a more generous treatment for investors in its Additional Tier 1 capital, should the capital be written-off, than most other banks.

More on this later.

The Bendigo Floating Rate Capital Notes (ASX code: BENHB) are the least complex of the hybrid securities BEN has on issue. The FRCNs are perpetual preference shares on which coupons can be deferred but, if deferred, will accumulate. The BENHB notes can also be redeemed at any time, subject to APRA approval.

The notes have been progressively redeemed and now only A$35 million of notes remain outstanding.

The Bendigo Preference Shares (BENPB) qualify as transitional Additional Tier 1 capital. They were issued before the Basel III rules on Additional Tier 1 capital came into effect.
As such, dividends are discretionary and non-cumulative but there are no provisions for mandatory conversion into ordinary equity or write-off. While there is provision for the BENPB notes to be perpetual, they are expected to be called by BEN in June 2015.

However, the Bendigo Converting Preference Shares (BENPD and BENPE) are fully Basel III compliant. Thus dividends are discretionary and non-cumulative, and the notes include capital and non-viability triggers that can cause the notes to be converted into ordinary equity or written-off, if pulled.

Conversion or write-off of the notes will inevitably result in capital losses for note holders. While conversion may not result in a complete loss of capital, a write-off typically will.

However, BEN provides for note holders to be treated as shareholders in a subsequent winding-up of BEN, if the notes are written-off beforehand. The note holders will be treated as if conversion had taken place.

Of course, this concession may be worth very little, as it is unlikely that shareholders would recover anything at all in a winding-up of the bank.

NAB also makes this concession for holders of its Additional Tier 1 capital. ANZ, CBA and Westpac do not.

There is also a range of different hybrid notes issued by Australian companies listed on the ASX. Each one of these comes with differing terms and conditions and any investor contemplating purchasing these notes should fully acquaint themselves with the prospectus for the issue first.

Understanding the differences between them is imperative. Some were issued with 60 year terms to maturity - you might not be around to get your money and neither might your kids. Your grandkids might thank you though.

The bottom line for potential investors is know what you are buying. But as a general rule, the older the issue, the more investor friendly the terms and conditions that apply.