New bank covered bonds weigh on hybrid prices

Co-founder of the Switzer Report
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The first domestic issues of covered bonds in Australia by the banks have caused quite a stir. While these bonds are only available to institutional investors, the pricing has important ramifications for hybrid securities.

Covered bonds explained

In case you’re not up to speed with the jargon, a covered bond is a debt instrument secured by a segregated pool of assets. These assets ‘cover’ the bond. For Australian banks, this cover (or security) is made up of a diversified portfolio of high-quality residential and commercial mortgages.

Typically, the cover exceeds the value of the bond – a legislated minimum of 103%. However, Westpac had a cover of 119.5% at its recent issue on 24 January. That is, for every bond of $100, there is $119.50 of mortgage principal behind it. Further, as both the debt (bond) and the underlying mortgages remain on the Bank’s balance sheet, in the event of a default, investors who have bought the bonds have recourse to both the asset pool and the Bank. Covered bonds are thus premium securities.

Hybrids are securities in a company that pay a fixed or floating rate of interest for a set period of time, after which, they are often convertible to shares.

New source of bank funding

Under the Banking Act, banks were barred from issuing covered bonds because depositors have first claim over a bank’s assets. But as a post-GFC initiative to help provide the banks with access to affordable funding, the Treasurer announced in late 2010 a plan to change the Act, and changes were finally given royal assent in October 2011. One of these changes was to limit the issuance of covered bonds to no more than 8% of a bank’s Australian assets.

Following a couple of offshore issues, Commonwealth Bank (CBA) and then Westpac tapped the domestic market in January. CBA issued $3.5 billion of five-year bonds at an effective margin of 175 basis points (or 1.75%) on 17 January, and Westpac $3.1 billion of five-year bonds at 165 basis points. Reflecting a fairly strong market reception, NAB is also reportedly in the marketplace.

The CBA and Westpac issues are AAA rated securities, and when swapped back into a floating rate exposure, CBA borrowed money at the 90-day bank-bill rate plus 1.75%, Westpac at 90-day bank-bill plus 1.65%. These are big rates and highlight why the banks are screaming about their cost of funding going up!

The impact on hybrids

What has this got to do with the hybrid securities market? While they are different markets and potentially target different investors, they do share some things. Many institutional fixed-income investors also buy hybrid securities, and are constantly looking for the security that offers the best return for the right risk. In effect, if institutional investors sell hybrids in favour of covered bonds, the price of hybrids will fall back (and yields will rise).

Further, as borrowers, banks will tend to favour issuing into the market that offers the lowest effective borrowing cost given the relative security they offer to the investor. If markets were truly efficient, price changes in one market would rapidly impact the other market.

Hybrids are overpriced

We did see some reaction in the hybrid market, with prices falling from what were clearly overbought levels. The CBA PERLS V (ASX:CBAPA) issue fell from $206.00 on the 19 January to $203.10 by 23 January, and has now settled at about $204.00. The recently issued ANZ CP3 (ASX:ANZPC) touched $104.00 in early January, and has now fallen back to around $102.00.

And the point of this story – it’s important to keep track of what is occurring in related markets.

The hybrid market trades on a very inefficient basis, with daily instances of mispricing. However, eventually some level of ‘efficiency’ is achieved. Credit markets globally remain skittish and in the current environment, our local hybrid market is overpriced. We are going to see more issues at attractive margins.

The recently issued Woolworths Note (ASX:WOWHC) is a good example of a note that is now overpriced. It has been trading up towards $106.00. While it goes ex-distribution on 10 February ($1.98 payable on 24 February), its effective trading margin is down to the 90-day bank-bill plus 2.20% – not bad for those who bought the initial issue at $100 each and a margin of bank-bill plus 3.25%!

A hybrid to watch

On the buy side, one hybrid I’m keeping an eye on is the original NAB Income Securities (ASX:NABHA). Launched way back in 1999, this $2 billion perpetual issue continues to have relatively good liquidity. In the heights of the GFC, the traded price crashed from a little over $100 to around $60 as interest spreads blew out. It has now settled around $77.50, having traded on the ASX in a range of $73.10 to $84.00 during the last 12 months.

It’s not quite in ‘buy’ territory, however at around $75 I may be tempted. At $77.50, the experts at Davies, Wood & Partners calculate the effective trading spread to be bank-bill plus 3.04%. The mathematics of pricing a perpetual security is beyond most of us – and as this security continues to qualify as Tier 1 capital for NAB, I would rather assume that the security will never be redeemed and look at it on a running yield basis.

It pays the 90-day bank-bill rate plus 1.25% on the whole $100 face value. So at $77.50 and the 90-day bank-bill rate at 4.36%, the running yield is 7.23%.

(4.36% + 1.25%) ÷ 77.50 = 7.23% running yield

That’s an effective trading margin of 2.88%. At a price of $75.00, the effective margin is 3.12%, which looks like good value compared to a NAB term deposit.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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