In recent weeks we have written to our clients and to the media about our concerns about the proliferation of “equity hybrids”. Equity hybrids, as opposed to debt hybrids, are hybrid securities that we believe have a risk exposure akin to equities, not bonds due to the ability of banking regulators to force their conversion to equities without any ability of hybrid investors to control this outcome. More concerning is the fact that Australian investors have invested a total of $20 billion in these securities, including the recent $2.5bn CBA hybrid PERLS VII.
This debate about the complexity of the risks of these securities continues to rage globally. The UK banking industry’s self regulation body, the FCA, has imposed a ban on its members issuing these securities. The EU’s equivalent regulator is doing the same. The media has joined the debate with the Economist most recently writing: “Cocos [the term used in Europe and the US] take multiple forms, but all are intended to behave like bonds when times are good, yet absorb losses, equity-like, in a crisis”.
On September 18th, Standard & Poor’s announced that they would be downgrading more than 80% of the world’s Cocos. Their concern, like ours, is that the timing of the conversion into equity is uncertain. Regulators could choose to act some time before the bank becomes “non-viable”. This is not a question of a bank actually being non-viable, but a question of at what point prior to that does the regulator choose to act.
Standard & Poor’s comments:
“Frameworks are generally favoring a "bail-in" approach that increases the possibility of regulatory intervention before a bank’s non-viability … to enforce loss absorption on hybrid capital instruments. This increases the likelihood of nonpayment via coupon deferral or loss of principal that we would consider to be defaults on these instruments. We believe that regulators expect hybrid capital instruments to absorb losses at an earlier stage in the deterioration of a bank than previously, and that the timing of regulatory intervention is now less predictable”.
In their 29 page report issued last week, S&P released their new methodology for rating these securities. Our conclusion is that they will downgrade Australia’s major four banks’ hybrids by either 1 or 2 notches from their current BBB to either BBB- or BB+. BB+ is “sub-investment grade”, “speculative grade” or euphemistically “junk”.
The major banks are rated AA- for their senior debt. BBB- has been 9 times more likely to default than AA-, using historic trends. This provides investors a guide to how much riskier S&P considers the hybrids compared to the senior debt of the same banks, yet many investors believe the risk to be similar.
The timing of the downgrade could be within the next two weeks. The impacted securities will be:
• NABPA
• NABPB
• WBCPD
• WBCPE
• CBAPC (Perls VI)
• CBAPD (Perls VII)
The point? Investors don’t need to be concerned about S&P’s change in the rating per se, and some investors choose to ignore S&P’s ratings often for justifiable reasons. However, a downgrade to BBB- or BB+ will have knock on impacts that investors need to understand.
A downgrade of the major banks’ hybrids to BBB- or worse, to BB+, will force a lot of investors to sell.
There are two reasons for this:
1. Fund managers’ mandates limit/ prevent holding of BBB- securities, and often completely prevent the holding of BB+ securities. That means they will have to sell these securities either before the downgrade or immediately afterwards.
2. Financial planners, whose clients are major holders of these securities, are required to only use investments on their licensee’s “approved product list”. This list typically prohibits holding BB+ or even BBB- securities, drawing the line at BBB most commonly.
Such a high volume of forced sellers will put downward pricing pressure on these hybrids. This is precisely the point we have been making about the risk associated with equity hybrids. It is not that we are concerned about the viability of any bank in Australia at present. It is that these new securities are engineered for a specific purpose, namely to be used to “bail-in” capital in the event that the banking regulator becomes concerned. This is a post-GFC device that as yet is untested. Markets don’t know how to price this risk and regulators are still shifting their rhetoric around how they will use their right to force conversion.
All of this leads to price volatility for the hybrids involved. And at the current returns on those securities, we do not believe investors are being compensated for the associated risks.
For more information see:
• FIIG’s three articles on the introduction of Cocos: here are links to Part One, Part Two, and Part Three.
• FIIG research highlight the risks in new-style subordinated debt and hybrids.
• The Financial conduct Authority (UK regulator) bans the sale of Cocos to retail investors, deeming them inappropriate risk for the mass retail market.
• FIIG’s article in The Wire warning of the risks in bail-in hybrids.
• The Economist article warning of the risks of new style bank hybrids (Cocos).
