Westpac is the first borrower to tap the hybrid securities market this year, taking advantage of falls in borrowing margins, as retail investors chase yield and wholesale investors develop a renewed appetite for risk.

The Bank has launched a $500 million issue of ‘Westpac Capital Notes’. This hybrid issue is structured on the same basis as the very successful PERLS VI issue from the Commonwealth Bank, and follows on issues from Suncorp, Bendigo and BOQ. The funds raised will qualify as Tier 1 capital for Westpac under the new APRA rules.

The Westpac Capital Notes 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 3.20% to 3.40%.

With the 90-day bank bill rate around 2.95%, this implies a gross dividend rate of 6.15% pa for the first three months (2.95% plus 3.20%). The actual dividend in cash, which is fully franked, would be 6.15% x (1 – Company Tax rate) = 6.15% x 0.70 = 4.31% pa.

While these Notes are perpetual and have no term, Westpac must (subject to a test) convert the Notes into ordinary shares on 8 March 2021 (in about 8 years). If conversion occurs, holders are issued Westpac 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 $15.80, then the conversion occurs – otherwise, it is retested on the next and subsequent dividend dates until the test is met.

In order to qualify as Tier 1 capital, there are two further conversion triggers    – a ‘capital trigger event’ and a ‘non-viability trigger event’. Under these tests, APRA can require Westpac to immediately convert the Notes into ordinary shares if Westpac’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 8.15% as at 30 September 2012), or if APRA believes Westpac needs an injection of capital to remain viable. Due to a cap on the maximum number of ordinary shares that are issued upon conversion, a Note holder could, under these scenarios, receive less than $100 of ordinary shares.

Dividend payments are discretionary and subject to the ‘distribution payment conditions’ being satisfied. They don’t accrue if not paid, and won’t subsequently be paid. The main protection Note holders have is that if a dividend is not paid, a dividend stopper is placed on Westpac ordinary shares.

Westpac also has a “once” only call option on 8 March 2019 (in six years), which allows it to redeem the Notes by paying holders the face value.

Details of the issue are in the table below.
The institutional book build (scheduled for Wednesday) will set the final margin.

Our View

The PERLS VI issue from the Commonwealth Bank was issued at a margin over the 90-day bank bill of 3.80% in September last year. On Friday, it closed at a price of $103.68 – which implies a margin of 3.11% to its call date. This shows how much margins have been compressed as investors chase yield.

90-day term deposits are yielding around 4.30% – an effective margin of 1.35% to the 90-day bank bill rate. While bank shares are an alternative, if you are looking to stay within the cash/fixed interest asset class, there isn’t really a lot around. Is the margin on a bank hybrid security of 3.2%, compared to the margin of 1.35% on a bank term deposit, worth the extra risk?

We think that in this case and in these market conditions, it is – and while there are likely to be other hybrid issues in the coming months, this Westpac issue will be very keenly sought.

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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