Bank shareholders will have noted a flood of capital note (also called ‘bank hybrid’) issues. A $500m offer of Macquarie Bank Capital Notes 3, $1.45bn of Westpac Capital Notes 8 and $375m of Suncorp Capital Notes 4.
It is unlikely, however, that many investors read in detail the accompanying PDSs (product disclosure statements). Here is section 5.15 from the Westpac issue:
“5.1.5 The liquidity of the Notes may be low
The liquidity of the market for the Notes may be impacted by a number of factors, including changes in law such as the new product design and distribution obligations that come into force in October 2021. The impact of those obligations is untested but they may affect the liquidity of funding instruments (including Additional Tier 1 Capital securities such as the Notes) if they lead to a material reduction in future issuance volumes or secondary market trading activity by investors. If they increase the difficulty of undertaking further issuance of Additional Tier 1 Capital securities such as the Notes, this could also in turn affect the likelihood of Westpac electing to Redeem or Transfer the Notes rather than Converting them”.
Macquarie refereed to the DDO (Design and Distribution Obligations) Legislation in Section 4.1.29 of its PDS, Suncorp in Section 5.2.2. This law comes into effect on 5 October – and issuers are rushing to issue ahead of the deadline.
The DDO legislation requires issuers of financial products (such as a Bank issuing capital notes) to prepare a target market determination – effectively a statement setting out who the product is suitable for – and then take reasonable steps to ensure that the distribution of the product is consistent with that determination. In the case of capital notes, this could lead to issuers (banks) taking a conservative approach and only offering new issues to “wholesale” investors. In other words, there would be no new issues to retail investors.
The legislation also gives ASIC the power to issue a product intervention order if it believes that a financial product has or is likely to result in significant detriment to retail investors. ASIC has had this power for almost two years and hasn’t used it in relation to capital notes – but nonetheless, the power exists.
Importantly, ASIC’s powers don’t apply to issues that are already trading on the ASX.
Each issuer points out in their PDS that the impact of the obligations is untested. But, there is a risk that new issues are smaller, there may be a decline in secondary market trading activity if capital notes fall off the “buy list” from financial planners, or issuers delay calling issues and let them run to their mandatory exchange date.
When I asked Chris Joye from Coolabah Capital about this on Friday at the Switzer Listed Investment Conference, he didn’t appear too concerned about DDO. He acknowledged that this may lead to smaller issues and less appetite from retail investors, but the supply and demand offset might be fairly neutral.
Post 5 October, we will see whether any of the major banks is “brave” enough to publish a market determination saying that capital notes are suitable for particular retail investors (existing bank and capital note holders, advised clients of stockbrokers and financial planners etc). My guess is that if one bank does, the rest will follow suit and DDO may become a “non-issue”.
Now to the issues themselves. Macquarie has closed and is trading on the ASX under MBLPD, Westpac’s issue (Westpac Capital Notes 8) closes this Friday and Suncorp’s Capital Notes 4 is expected to close on September 20. So let’s focus on the Westpac and Suncorp issues.
Both issues are offering a fixed margin of 2.9% over the benchmark 90 day bank bill rate – the rate banks lend money to each other for 90 days. While the margin is fixed, because the 90 day bank bill rate can vary, capital notes are floating rate securities. Each quarter, the distribution rate is re-set by reference to the benchmark rate.
Over the last 30 years, the 90 day bank bill rate has been as high as 20.5% and as low as it is today at 0.01%. Yes, you read that correctly……….0.01%. So, for the first 90 days of these capital notes, the gross distribution will be at a rate of around 2.91%. If down the track the 90 day bank bill rate increases to 1%, the gross distribution rate will rise to 3.9%.
These rates are quoted on a “gross” basis. The distributions are fully franked, but they are adjusted down for the benefit of the franking credits. In cash terms, you only receive 70% of the distribution – the remaining 30% comes from the franking credits.
Using a 90-day bank bill of 0.01%, the cash distribution for 90 days will be calculated using a rate of (2.91% x 0.7) = 2.037%. There will also be franking credits worth 0.873%.
It is important to note that distributions are discretionary – that is, the Bank is not obliged to pay them. They are subject to payment conditions and are also non-cumulative. However, to protect note holders from the discretion being miss-applied, the Bank is then restricted from paying a dividend on its ordinary shares.
Technically, capital notes are perpetual and have no term. They are designed as “loss absorbing securities” such that if the Bank gets into trouble, they become permanent capital. They convert into ordinary shares.
There are two defined triggers for this exchange, a ‘capital trigger event’ (for Westpac) and a ‘non-viability trigger event’ (for both Banks)’. The first is triggered if Westpac’s Common Equity Tier 1 Ratio falls below 5.125% (its ratio on 31 March was 12.3%). The ‘non-viability’ event is triggered if APRA believes that the Bank needs an injection of capital to remain viable, and the capital notes are converted into ordinary shares. In these distressed circumstances, conversion would most likely result in a holder receiving considerably less than $100 of ordinary shares as there is a cap on the maximum number of shares that can be issued.
Capital notes do have a scheduled conversion date. For Westpac, this is in 10.75 years on 21 June 2032, while for Suncorp it is in 9.25 years’ time on 17 December 2030. Provided the Bank’s share price has not collapsed, this is the date your capital notes will be exchanged into $101 of ordinary shares. That is, for every $100 capital note, you will get $101 of ordinary shares.
If economic conditions are good and the Bank is travelling ok, a more likely scenario is that the Bank will call the issue early (that is, redeem the issue and give you your $100 back). Westpac Capital Notes 8 have four call dates (starting in 8 years’ time on 21 September 2029) while Suncorp has three call dates commencing in 6.75 years’ time on 17 June 2028.
Should you invest?
Capital notes are complex instruments and I work on the principle that “never invest in something that you don’t understand”. But if you understand these notes and are comfortable with the risks, including the DDO risk, they are attractively priced compared to the current secondary market which is trading at an equivalent fixed margin of around 2.5%.
Margins in the hybrid market are nearing decade lows, but this is true of most fixed interest securities as spreads have compressed due to the demand for yield. Additionally, bank capital ratios have never been higher meaning that he risk profile of capital note securities has improved.
Notwithstanding its extra length with a term of 10.75 years to its scheduled conversion, Westpac Capital Notes 8 is the pick. With due respect to Suncorp. It’s a ‘second tier’ issuer and its notes won’t be as liquid as Westpac’s. Westpac’s offer closes on Friday – shareholders and existing Westpac capital note holders can apply at https://events.miraqle.com/Westpac-Capital-Notes-8-Offer/Country-Validation/
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 regard to your circumstances.
