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Hybrid prices to fall further

by Craig Swanger | Sep 29, 2014

Key points:

  1. Over half of the new “bail-in” hybrids trading on the ASX are now below par due to increased concern from regulators in Australia and globally around the complexity and risk of these “equity” hybrid securities
  2. Australian bank hybrids are pricing at tighter levels than European banks with investors in Europe requiring an equivalent minimum margin of 4.00% versus 2.80% for the recent CBA Perls VII issue  
  3. Standard & Poor’s (S&P) announced on the 18 September that they would be downgrading 80% of the world’s CoCos, many by two notches.  This is because they are increasingly concerned that the regulators will act well ahead of “non-viability” where they can
  4. Investors may experience further price volatility as a result of the S&P downgrades and the market reassessing the “bail-in” hybrids risk in line with international investors assessment

Last week, FIIG made the following announcement warning of the potential for a further decline in value of bank hybrids over the next few weeks.

Fixed income specialist FIIG Securities has warned of the potential for further drops in the value of bank hybrids over the next few weeks.  Prices on the several of the largest hybrids on the ASX have fallen by $4-5 and are now below issue price in many cases, but more falls are likely to be driven by ratings agency Standard & Poor’s announcement that it will downgrade the securities within weeks.

FIIG Head of Markets Craig Swanger said S&P’s move, which it flagged in a report last week, may force many fund managers still holding these securities and financial planners to sell the hybrids because they were not allowed to hold investments below investment grade.

“A downgrade of the major banks’ hybrids below investment grade, will force a lot of investors to sell adding to recent selling pressure,” Mr Swanger said.

“Such a high volume of forced sellers is likely to put downward pricing pressure on these hybrids which reinforces our view that they are very volatile and investors are not being fairly compensated for the associated risks.  We believe recent price moves have moved prices closer to the sorts of levels that hybrids trade at in Europe. ”

“The recent CBA Perls issue was done at 2.8% over BBSW (being about 5.4%pa).  Bank hybrids in Europe are trading at around double this level, but even if at the lowest end of the European range, the CBA deal should have been around 400bps over (or 6.6%pa).  If the Australian hybrids corrected to that sort of yield, their price would fall to $95-96.” 

Mr Swanger said the re-rating would affect the new generation of “equity hybrids” or “CoCos” (Contingent Convertibles) which were structured to allow banking regulators to convert them into equity in times of crisis, not the older hybrids like ANZPA that are structured more like bonds.

These new generation of hybrids include NABPA, NABPB, WBCPD, WBCPE, CBAPC (Perls VI) and CBAPD (Perls VII).

Australian investors have invested a total of $20 billion the equity hybrids, including the recent $2.6bn CBA hybrid PERLS VII. 

Mr Swanger said the volatility of the hybrids did not reflect concerns about the viability of any bank in Australia.

“The problem is that these new securities are engineered for a specific purpose, namely to be used to “bail-in” capital in the event that the banking regulator becomes concerned,” Mr Swanger said.

“This is a post-GFC device that as yet is untested so markets don’t know how to price this risk and regulators are still shifting their rhetoric around how they will use their right to force conversion.” 

Mr Swanger said the major banks were highly rated for their senior debt, while their hybrids were likely to be downgraded to the lowest levels of investment grade or even sub-investment grade. The changes in credit rating imply a nine times higher chance of default, using historic trends, showing how much riskier S&P considered the hybrids compared to the senior debt of the same banks, yet many investors apparently believed the risk to be similar.

The UK’s financial services watchdog, the FCA recently banned the issue of CoCos to retail investors while the EU equivalent, the EMA, has flagged it is likely to follow.

By contrast, it has been open slather in Australia, despite ASIC warnings about hybrids last August.

FIIG does not distribute CoCos to retail investors.

About CoCos

Bail-in hybrids were created in 2009 in the UK, when Lloyds Group issued a new type of hybrid. The securities would be automatically converted into shares in Lloyds in the event that Lloyds’s capital fell to crisis levels.

Rather than the government being forced into further bail-outs, these new securities would convert from high-yielding hybrids into shares without the investor or even Lloyds itself having any choice in the matter.  In other words, the hybrid investors would be “bailed-in” to prop up the bank’s balance sheet.

Since then, European banks have issued around $110 billion (€75billion) in these hybrids (in Europe they are called “CoCos” short for Contingent Convertibles). Banks, and until recently regulators, have been pleased at the success of this financial innovation as it means bondholders and government bodies are far less likely to need to bail out banks in the event of a liquidity crisis like that seen in 2008. 

Banks are particularly keen to issue more of these securities because they are a cheap source of funding.  In a crisis, these securities act as a loss-absorber as banks don’t have to pay interest or repay the capital.  For this reason, European banks are expected to issue a further $240 billion (€100billion) in the next two years.  Yield hungry investors are expected to scramble for an allocation, with Deutsche Bank’s recent €1.5billion issue receiving €25billion in orders.

However, the tide is turning, with the UK’s financial services watchdog, the FCA, this month banning the issue of CoCos to retail investors.  The EU’s equivalent, ESMA, has flagged it is likely to follow.

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