Westpac launches new hybrid security with lower margin

Co-founder of the Switzer Report
Print This Post A A A

Margins continue to crunch in the hybrid securities market. Last Thursday, Westpac launched an issue of Capital Notes 2, which is likely to be priced at a margin of 3.05%. This compares to the last issue from the ANZ in March, which was priced at 3.25% and earlier issues, which were priced as high as 3.80%.

Westpac Capital Notes 2 follows the earlier Westpac Capital Notes (ASX Code WBCPD) issue, and issues from the other major banks, including ANZ Capital Notes 1 and 2 (ANZPD and ANZPE), Commonwealth Bank’s PERLS VI (ASX Code CBAPC) and NAB’s CPS I and CPS II (NABPA and NABPB). All these issues qualify as ‘Additional Tier 1 Capital’ and employ very similar structures.

Distributions

Westpac Capital Notes 2 will pay a quarterly floating rate distribution, which is expected to be fully franked. The distribution 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 3.05% to 3.25%.

With the 90-day bank bill rate around 2.68%, this implies a gross distribution rate of 5.73% per annum for the first three months (2.68% plus 3.05%). The actual distribution in cash, which is fully franked, would then be 5.73% x (1 – company tax rate) = 5.73% x 0.70 = 4.01% per annum.

The payment of any distribution is discretionary and subject to the distribution payment conditions being satisfied. If a distribution is not paid, it doesn’t accrue and won’t subsequently be paid. To protect Note holders from this discretion being misapplied, if a distribution is not paid, Westpac is then restricted from paying a dividend on its ordinary shares.

Conversion into Westpac shares

Westpac Capital Notes 2 are perpetual and have no term. However, Westpac must (subject to a test) convert the Notes into ordinary shares on 23 September 2024 (in about 10 years). If conversion occurs, holders are issued Westpac ordinary shares at a 1% discount to the then weighted average market price. The test for the conversion is the price of Westpac ordinary shares at the time – provided they are higher than approximately $19.60, conversion occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.

To qualify as Additional Tier 1 capital, there are two further mandatory conversion events – a ‘capital trigger event’ and a ‘non-viability trigger event’. Under these tests, the Australian Prudential Regulatory Authority (APRA) can require Westpac to immediately convert the Capital Notes into ordinary shares if Westpac’s common equity tier 1 capital ratio falls below 5.125% (the ratio was 8.82% as at 31/3/14), or if it believes Westpac 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 Westpac ordinary shares, as there is a cap on the maximum number of ordinary shares that can be issued.

Westpac also has a “once” only call option on 23 September 2022 (in about eight years), when it can elect to redeem the Capital Notes by paying holders the face value of $100, or converting the Notes into Westpac ordinary shares.

Details of the issue are as follows:

The institutional book build on Wednesday will set the final margin (likely to be 3.05%).

How does this issue stack up?

In terms of pricing, 3.05% is the going margin for these types of bank issues in the secondary market (i.e. as traded on the ASX). Spreads have tightened over the last 18 months – from 3.80% down to an expected 3.05% for this issue.

In terms of how to categorise an investment in securities like Westpac Capital Notes, I suggest you include these within your asset allocation to fixed interest securities or bonds. As this is a floating rate security, it will suit an investor who expects interest rates to increase over the medium term. If you are expecting interest rates to decrease, look to acquire bonds or long dated term deposits paying a fixed rate of interest, rather than a floating rate note instrument liked Westpac Capital Notes 2.

Should you invest in Westpac Capital Notes, Westpac Shares or a Westpac or other bank Term Deposit? While the answer to this question is probably not ‘one’ or the ‘other’ (it may indeed be all three) and will depend on your asset allocation, the following table highlights the key differences between the investments.

* Expected

Bottom line, however, is that margins are fairly fine and at only 1.93% over a government guaranteed term deposit (best rate available), the risk/reward equation is becoming marginal.

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.

Follow the Switzer Super Report on Twitter

Also in the Switzer Super Report:

Also from this edition

View More Articles