NAB’s new hybrid security

Co-founder of the Switzer Report
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After a drought of almost four months, the hybrid securities market has suddenly come to life with two new issues in the space of a few days: a $300 million subordinated note issue from AMP and a jumbo issue of at least $750 million from the NAB. When the window in this market opens, the borrowers and their advisers are pretty quick to roll out the new issues.

This NAB issue, Convertible Preference Shares II (or CPS II), is structurally very similar to raisings earlier in the year in the hybrid market from the major banks – ANZ Capital Notes (ANZPA), Commonwealth Bank’s PERLS VI (ASX Code CBAPC), Westpac Capital Notes (WBCPD), NAB’s first issue of Convertible Preference Shares (NABPA) and Macquarie Capital Notes (MQGPA). Like these earlier issues, the funds that NAB is raising will qualify as Additional Tier 1 capital.

Dividends

NAB CPS II will pay a quarterly floating rate dividend, which is expected to be fully franked. The dividend is set every three months at a fixed margin over the 90-day bank bill rate, and then adjusted for the company tax rate (to take into account the franking credit benefits). The indicative margin for this issue is in the range of 3.25% to 3.40%.

With the 90-day bank bill rate around 2.59%, this implies a gross dividend rate of 5.84% per annum for the first three months (2.59% plus 3.25%). The actual dividend in cash, which is fully franked, would then be 5.84% x (1 – Company Tax rate) = 5.84% x 0.70 = 4.09% per annum.

These CPS are effectively a form of capital for the NAB and the payment of any dividend is discretionary and subject to no ‘payment condition’ existing. If a dividend is not paid, it doesn’t accrue and won’t subsequently be paid. To protect CPS holders from this discretion being misapplied, if a dividend is not paid, NAB is then restricted from paying a dividend on its ordinary shares (‘dividend stopper’).

Conversion into NAB shares

NAB CPS II are perpetual and have no term. However, NAB must (subject to a test) convert the CPS into ordinary shares on 19 December 2022 (in about nine years). If conversion occurs, holders are issued NAB ordinary shares at a 1% discount to the then weighted average market price. The test for the conversion is the price of NAB ordinary shares at the time – provided they are higher than approximately $19.04, then the conversion occurs – otherwise, it is retested on the next and subsequent dividend dates until the test is met.

To qualify as Additional Tier 1 capital, there are two further conversion triggers (known as “loss absorption events”) – a ‘common equity trigger event’ and a ‘non-viability trigger event’. Under these tests, the Australian Prudential Regulatory Authority (APRA) can require NAB to immediately convert the CPS into ordinary shares, if NAB’s common equity tier 1 capital ratio falls below 5.125% (the ratio was 8.43% as at 30/9/13), or if it believes NAB needs an injection of capital to remain viable. In these distressed circumstances, conversion would most likely result in a holder receiving considerably less than $100 of NAB ordinary shares, as there is a cap on the maximum number of ordinary shares that can be issued.

NAB also has a “once” only call option on 17 December 2020 (in about seven years), when it can elect to redeem the CPS  by paying holders the face value of $100, or converting the CPS  into NAB ordinary shares.

Details of the issue are as follows:

The institutional book build on Tuesday will set the final margin.

Our view

Over the last few months, margins in the hybrid securities market have come down due to the lack of new supply, and a general tightening in margins in the institutional bond markets. At an indicated margin of 3.25%, this issue is priced on par with the existing secondary market issues (ANZPA, NABPA etc).

That said, new issue margins for securities from the major banks of this type have ranged from 3.20% to 3.80%, so at 3.25%, this is no standout. With the prospect of more issues in the pipeline, and the likelihood that any surplus demand will be met by an increase in the issue size, hybrid investors and others building a portfolio of securities may want to keep some powder dry. It is unlikely that this issue will trade at much of a premium (if any) when it lists on the ASX.

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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