On Friday, Westpac announced that the offer size for its new hybrid security issue, Westpac Capital Notes 5, had been increased to $1.45 billion and the margin set at the bottom of the range. While this suggests that underlying demand is pretty strong, I think that this is an issue that it may pay to sit out on. It is no bargain.
And while I am a fan of hybrid securities for investors who understand the product and the risks, like all markets, there can be times when it pays to just sit out. With the recent move higher in bank ordinary share yields, I think the hybrid market is at this point at the moment.
I will come back to this a little later, but firstly, the details of the issue.
Westpac Capital Notes 5
Westpac Capital Notes 5 will pay a quarterly distribution, which is set at a fixed margin of 3.20% over the 90-day bank bill rate, and then adjusted for the company tax rate (to take into account the franking credit benefits).
With the 90-day bank bill rate around 1.75%, this implies a gross distribution rate of 4.95% pa for the first 3 months (1.75% plus 3.20%). The actual distribution in cash, which is fully franked, would then be 3.465% (4.95 x 0.70 = 3.465%).
Distributions are discretionary and subject to distribution payment conditions. If a distribution is not paid, it doesn’t accrue and won’t subsequently be paid. To protect holders from this discretion being miss-applied, if a distribution is not paid, Westpac is then restricted from paying a dividend on its ordinary shares.
Conversion into Westpac shares or early repayment
These Notes are perpetual and have no term. However, Westpac must (subject to a test) convert the Notes into ordinary shares on 22 September 2027 (in about 9.5 years). If conversion occurs, holders are issued $101.01 of Westpac ordinary shares for every Note of $100 face value (which effectively means that they are issued Westpac shares at a 1% discount to the then weighted average market price). The test for the exchange is the price of Westpac ordinary shares at the time – provided they are higher than approximately $17.07, conversion occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.
To qualify as regulatory capital for Westpac, 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 Westpac Capital Notes 4 into ordinary shares if Westpac’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 10.1% as at 31/12/17), 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 an option to redeem the Notes in approximately 7.5 years’ time on 22 December 2025. It can redeem or transfer the Notes by paying holders $100 per Note.
Details of the issue are as follows:
Westpac is also conducting a re-investment offer for holders of Westpac CPS (ASX Code WBCPC)
How to invest
The offer is due to open Tuesday 13 February. A number of brokers can offer stock firm. Brokers involved include Westpac Online Broking, CommSec, JB Were, Macquarie, Ord Minnett and Shaw.
Westpac ordinary shareholders and Capital Note holders can also access stock directly from Westpac through a Securityholder offer (go to https://events.miraqle.com/Westpac-Capital-Notes-5-Offer/Country-Validation/
And if you are investing via a broker or financial planner, most are receiving a placement fee of 1% and in some cases, may be willing to share some or all of this with potential investors.
My view
This issue is reasonably priced compared to existing secondary market yields. Westpac Capital Notes 4 (WBCPG) and Westpac Capital Notes 3 (WBCPF) last traded on Friday at margins of 3.17% and 3.07% respectively.
However, I don’t like Capital Notes 5 for three reasons.
Firstly, the call date is 7.5 years out which is long compared to the typical call date of 5 to 5.5 years. Although the issuer has no obligation to do so, and arguably should only call an issue if it is in their interest to do so, most bank issues tend to be called. Further, the market prices hybrid issues on the secondary market as though they will be called.
Next, by historic standards, the margin is low. Over the last few years, bank hybrid issues have had margins ranging from a low of 2.8% for CommBank’s PERLS VII to a high of 5.2% for CommBank’s PERLS VIII. At 3.2%, Westpac Capital Notes 5 are at the bottom end of the range.
Finally, and perhaps most importantly, the hybrid market has yet to adjust to the recent increase in bank ordinary share dividend yields following the pullback on Wall Street and the ASX. While bank ordinary shares and bank hybrid securities are different securities and arguably different asset classes (equity for the former, “risky” fixed interest for the latter), they do carry some of the same underlying risks. On previous occasions, when there has been a sell off on in bank ordinary shares, hybrid securities trading on the ASX have fallen in price in the following weeks.
Here is the comparison on a cash and gross (post franking) basis between Westpac Capital Notes 5 and the closing yield on bank ordinary shares on Friday (1 year forecast from FN Arena).
* Closing price 9/2/18, forecasts from FN Arena for FY18 dividends. Capital Notes 5 using current bank bill rate of 1.75%
On this basis, Westpac Capital Notes 5 don’t look particularly attractive.
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.
