Should you be wary of the latest hybrid fund raising offer from a bank which emerged yesterday? It all depends on what you want from such an issue (and if you want it at all). The end decision is yours, and it will pay to do your homework.
More than $A7 billion of hybrids were issued by large companies in 2011-12 – most by banks and groups like Woolworths. They sell on their higher yields (usually a set or floating interesting rate that is well above bank deposit rates) that apparently appeals to yield hungry investors of all sizes.
There are some pitfalls and there are some advantages in these securities and the latest offer from Macquarie is no different.
Macquarie Group revealed plans yesterday to raise at least $400 million and possibly more to replace an existing $A600 million of convertible preference share issued in 2008 and to raise fresh capital if there’s enough money left over.
Given the yield is fairly predictable (these notes pay a margin of 4% to 4.2% over the 180 day bank bill swap rate) for a total payout (twice a year in arrears) of more than 6.8% at the moment, they can be seen as attractive.
The notes are fully paid, subordinated, non cumulative, unsecured, mandatory convertible notes in which will trade on the ASX.
These terms mean that the notes are subordinated to all other debt, but rank just above ordinary shares, they will be converted to Macquarie shares on June 21, 2021 mandatorily (you have no say) if you hang on that long. The dividend is non-cumulative – which means if for some reason an interest payment is missed it is gone for ever and doesn’t carry on as a debt to you from Macquarie.
Hybrid securities rank above ordinary shares (but below senior debt and similar securities). In the case of this issue of Macquarie Capital Notes, they rank just above ordinary shares but under previous issues of convertible preference notes and are therefore well down the pecking order of security
The notes will be issued with a face value of $100 each.
Macquarie looks to tap demand for hybrids
"The Macquarie Note Offer is consistent with Macquarie’s strategy to manage its capital mix and maintain a diverse source of funding," Macquarie chief financial officer, Patrick Upfold, said in yesterday’s announcement.
“Macquarie has a strong balance sheet with well diversified funding sources and minimal reliance on short term wholesale funding markets," he added
Holdings of the existing convertible prefs are being encouraged to roll these securities into the notes (but they don’t have to) and the issue has approval from the Australian prudential regulator. But the new notes rank lower than the convertible preference shares.
Existing Macquarie shareholders will be given preference to the new issue.
It is important you read the prospectus, especially the first chapter which details the terms and conditions of the issue. And you should also read this commentary on hybrids.(http://www.perpetual.com.au/advisers-snapshot-wolf-in-sheeps-clothing.aspx) from Perpetual senior portfolio manager, Vivek Parbhu which was published in March of this year.
"The current generation of bank hybrids offer much less certainty to investors. Certainty of income is lower, as coupon payments are required to be discretionary and non-cumulative, more characteristic of dividend payments from equities but without the upside true equity risk can offer," Mr Parbhu wrote.
"Similarly, certainty of principal repayment is also reduced, as under the most recent banking regulations (Basel III), the banking regulator can mandatorily instruct hybrids to be written off or converted into equity in certain circumstances.nvestors have a choice of where to invest in the capital structure.
"At the least risky end of the spectrum are covered bonds (senior debt secured by collateral), followed by senior unsecured debt, subordinated debt (Tier 2 capital), hybrid debt (Tier 1 capital) and lastly equity. So are hybrid investors being adequately compensated for these increased risks, or is a wolf lurking beneath?
"Historically, each layer in the capital structure has offered a credit premium of approximately 1.5 to 2.5 times that of the layer which ranks above it. As indicated in the chart above, for debt issued by the major Australian banks, we currently see this credit risk best rewarded at the subordinated debt level.
"So when hunting for extra yield, fixed income investors should beware of hidden risks and invest where risk is best rewarded."
Macquarie says the semi-annual interest payments will be 40% franked (as the ordinary shares are at the moment), but this could rise or fall. These notes will trade like a fixed interest security, with probably a little bit extra performance because of their low ranking compared with a fully secured bond.
There is one term in the prospectus you should be aware of and that "A viability event" which means that if the banking regulator suddenly says Macquarie Group is no longer viable as a bank, then the shares are forcibly converted into ordinary shares, which could produce losses.
Hybrids do not offer the gains that ordinary shares do. As Mr Parbhu suggests bank hybrids may not be every investors cup of tea.
