Macquarie Capital Notes – the risk premium is not there

Co-founder of the Switzer Report
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Macquarie Group is the latest to tap the hybrid securities market with an issue of $400 million Macquarie Capital Notes (MCN). The issue structure is similar to that used by Commonwealth Bank, Westpac, NAB, Suncorp and BOQ in recently accessing the hybrid market through issues of listed preference shares (ASX Codes CBAPC, WBCPD, NABPA, SUNPC and BOQPD).

Although technically not a preference share, the Capital Notes are perpetual and will qualify for Macquarie as regulatory capital with APRA. Subject to a couple of testing conditions being met, they will convert into Macquarie ordinary shares in about eight years’ time.

The Notes will pay a semi-annual floating rate distribution, which is expected to be partially franked. The distribution is set every six months at a fixed margin of 4.0% over the then 180-day bank bill rate, and then adjusted for any franking credits that are attached.

With the 180-day bank bill rate currently around 2.75%, this implies a gross distribution rate of 6.75% per annum for the first six months (2.75% plus 4.0%). As this is expected to be franked at 40%, the cash distribution should be 5.76% per annum, which will also carry a (non-cash) imputation credit of 0.99% per annum.

The conversion test

Macquarie must convert these Notes into ordinary shares on 19 June 2021. Upon conversion, holders are issued Macquarie shares at a 1% discount to the then market price. The first test for the conversion is the price of Macquarie shares in June 2021, which needs to be at least 56% of the price Macquarie is trading at today. With Macquarie around $45.00 today, this implies a test condition of around $25.20. If this and the other conditions are met, conversion occurs – otherwise, it is retested on the next and subsequent distribution dates until the test is met.

There is also a ‘non-viability event’ trigger. Under this trigger, APRA can determine that Macquarie Group is ‘non-viable’ and require the immediate conversion of the Capital Notes into ordinary shares. Due to a cap on the maximum number of ordinary shares that are issued upon exchange, a MCN holder could receive less than $100 of ordinary shares.

Distribution payments are discretionary. They don’t accrue if not paid, and won’t subsequently be paid. The main protection MCN holders have is that if a distribution is not paid, a dividend stopper is placed on Macquarie ordinary shares.

Macquarie also has three optional exchange dates – five, five and a half and six years down the track – on which they can elect to exchange the Notes for ordinary shares, or with the permission of APRA, redeem or resell the Notes.

Details of the issue are as follows:

Our view

It wasn’t that long ago that Macquarie shares were trading under $20 – they have had a great rally to around $47. This highlights not only how fickle the market can be, but also the additional risk in investing in a Macquarie equity investment.

That said, Macquarie boasts a pretty impressive set of metrics:

  • A capital surplus of $3.4 billion above the harmonised Basel III requirement;
  • A conservative balance sheet with term assets covered by term funding;
  • Retail deposit growth up 7% since March 2012; and
  • A claim that its earnings volatility (or more precisely, lack of it) makes it closer to a fund manager than an investment bank.

Is a margin of 4.0% a sufficient “risk” premium for this hybrid issue? In this yield driven environment, the market seems to think so, as the book build has reportedly gone very well. Maybe we are a little jaundiced, however September 2011 doesn’t seem that long ago. On a risk-adjusted basis, the existing NABPA and WBCPD issues, which are trading on the ASX at a margin of around 3.25%, look better value.

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.

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