Key points

• Unlike the main sharemarket, where institutions and professional investors drive market action and prices, the hybrid securities market is largely a retail market.
• Ultimately, banks raising more capital, and strengthening their capital base, is a big positive for bank hybrid securities. It means that the triggers (‘common equity capital trigger’ or ‘non-viability’ trigger) are far less likely to be exercised.
• Consider hybrids as part of your “risky fixed interest” portfolio. A bit like a junk bond. Don’t be put off by the name – without taking risk, there is no return above the government bond rate. But, it should only be a small part of any portfolio.

Yield chasers should turn their sights to the bank hybrid securities market. On light volume, prices have headed south and, despite the recent recovery in bank ordinary share prices, hybrid securities are effectively yielding their highest margin in more than three years. While there is risk, there is also value.

The sell-off

There are a number of factors that influence the price of a hybrid security. One of these for bank hybrid securities is its relationship with the yield available on bank ordinary shares, as some investors tend to consider these as alternative investment options.

With concerns about capital raisings and talk that the yield trade might be over, bank share prices fell materially over April and May. For example, Commonwealth Bank ordinary shares peaked on 23 March at $96.69, fell to $79.19 on 10 June, and despite Friday’s sell-off, have climbed back to $86.65 – a rise of 9% from the bottom.

Less volatile bank hybrid securities followed bank ordinary shares down in price, but unlike the latter, haven’t bounced. The charts below show the prices for two benchmark issues – Commonwealth Bank’s PERL VII (ASX Code CBAPD) and ANZ’s Capital Notes 3 (ASX Code ANZPF) – which are both still trading around their lows.

CBAPD, Commonwealth Bank of Australia PRF

Source: ASX

ANZPF, ANZ Banking Group Conv PRF

Source: ASX

What other factors influence hybrid prices

The hybrid securities market is unique on the ASX. Unlike the main sharemarket, where institutions and professional investors drive market action and prices, the hybrid securities market is largely a retail market. While some smaller institutions participate, it is generally higher net wealth private investors, including SMSFs, who take part. Secondary market activity is very thin.

It is also a supply/demand market. New supply (as in new issues) has a huge impact on prices. However, both supply and demand are erratic.

In the case of the former, this is because the issuers are wholly opportunistic. Because of the very high costs of issuing to a retail market, banks only issue ASX listed hybrid securities when it is attractive to do so. If it is more cost effective (ie they pay a lower interest rate) to issue securities via a wholesale market, they ignore the hybrid securities market. This means that supply is often erratic and dependent on spreads in the wholesale market.

Secondary market demand is also very erratic, mainly because it is very difficult for private investors to compare effective trading yields.

Supply factors have not played a major role over the last few months, as there has only been one new issue (for Bendigo) and it is unlikely that the market will be tapped in the short term by further issues. Erratic and thin secondary market demand, responding to weaker bank ordinary share prices and the prospect of banks raising more capital, is the factor that has played the largest role.

Banks raising capital should be good for hybrid securities

While it is also possible that the spectre of banks raising more capital has had a negative impact on prices, as it could result in more hybrid issues, so far, this is yet to play out.

Banks are responding to these challenges by selling non-core assets, new equity raisings such as the NAB has undertaken, and not neutralizing/increasing investor incentives on dividend reinvestment plans.

Ultimately, banks raising more capital – particularly through the issue of ordinary shares – is a big positive for bank hybrid securities. The strengthening of the capital base and implied de-leveraging that occurs means that the triggers (‘common equity capital trigger’ or ‘non-viability’ trigger) are far less likely to be exercised – meaning that the worst case scenario for a hybrid security (the mandatory conversion back into ordinary shares) is an even more remote scenario.

Yields available

Detailed below are the secondary market trading yields for four hybrid issues – one from each of the major banks. There are more than 20 bank hybrid issues – so if the market is efficient, they should (for the same issuer) be trading at around the same margin.

Although the actual distribution paid is based on the issue margin plus the then current 90-day bank bill rate, the trading margin represents this return plus the expected price appreciation if the security is redeemed at $100. Prices are as at the COB on Friday, and assume that redemption occurs on the first date possible.

From the above table, the going rate is a trading margin of almost 4.0%. The CBA PERLS VII issue is a stand-out, impacted by its size and the fact that it has never traded above par, and possibly an expectation that CBA may not call it on the first date. If this happens, the conversion date slips two years to 15 December 2024 (into ordinary shares at a 1% discount).

Debt or equity?

I think the debate about whether hybrid securities are debt or equity is somewhat academic. While they have some equity like characteristics, I don’t consider them to be equity because they have no price upside. The maximum amount you will ever get back is the issue price of $100.

They also shouldn’t be considered in the same basket as a government guaranteed term deposit or government bond.

I consider them to be part of my “risky fixed interest” portfolio. A bit like a junk bond. Sure, you don’t enjoy the same rights as a creditor if something goes wrong, but they are issued by much stronger borrowers. And don’t be put off by the name – without taking risk, there is no return above the government bond rate. But, it should only be a small part of any portfolio.

How to play?

While it is very likely that if one major bank got into distress, it would impact the other banks and the prices of any securities they had issued, the old adage about issuer diversification really applies here. Issuer diversification is not about buying different issues from the same bank – it is about making sure you spread any investment across many different issuers. Build a portfolio covering all the major banks.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.