Key points:
- 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
- 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
- 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
- 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.
Copyright The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.
Disclaimer Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.
No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.
FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.
FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.
An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.
The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.