Capital Notes – Advantages and Disadvantages

Capital Notes – Advantages and Disadvantages

Recent new issues by NAB, Macquarie, and Ampol might have you thinking about adding capital notes, sometimes called ‘hybrids’ to your portfolio. In this article, we discuss the advantages and disadvantages to help you determine if they might be right for you.

A capital note is a hybrid product and is a perpetual, unsecured security that combines features of both shares and bonds – hence the term hybrid security. It is a way for banks and companies to borrow money from investors.

Like a share, most capital notes do not have a maturity date. Like a bond, they pay regular income. However, there are important distinctions between capital notes, shares and bonds, and some new regulations which we explore below.

Capital Notes Key Features

  • They belong to the fixed income asset class and are floating rate securities linked to a benchmark
  • Interest is paid quarterly and generally tied to the Bank Bill Swap Rate (BBSW). BBSW’s recent history can be found on the ASX website
  • Financial institution capital notes are regulated by APRA and designed to be ‘loss absorbing’ instruments:
    • Financial institutions must meet minimum capital requirements before converting to shares or being repaid on conversion dates
    • May convert to shares to help support the institution if it is under financial stress. The capital notes then lose the elevated position in the capital structure and in the worst possible outcome, if a bank fails, investors can lose all of their investment
  • The ASX listed Capital Notes market is fairly stagnant with few genuinely new issues coming to the market. The recent Macquarie Capital Notes 6 (ASX: MQGPF) was, unusually, a completely new issue. Most issuance is used to repay existing Capital Notes issues
  • The market is worth around AU$39 billion
  • New Design and Distribution Obligations (DDO) have meant recent new Capital Notes issues are only made available to wholesale investors or retail investors if they have received personal financial advice from a qualified financial adviser in connection with the new Capital Notes offer. See DDO Legislation Locking Out Retail Investors for more information and ASIC’s information page.

Also read: Capital Notes – What Are They and Should You Invest?

Capital Notes Advantages

  • Floating rate interest payments are attractive in rising interest rate environments. Income increases, helping your portfolio keep pace with inflation
  • Tradeable through the Australian Stock Exchange. While deposits are widely available, most corporate bonds and other fixed income investments need to be traded through a bond broker. Capital Notes, being available on the ASX are easy to transact
  • Provide a range of risk and returns
  • Issued by our largest financial institutions as well as smaller regional banks and other non-financial companies
  • Regulated products
  • Typically, provide reliable income and franking credits.

Capital Notes Disadvantages

  • Complex securities, where terms and conditions can vary even if issued by the same financial institution or company
  • Financial institutions must seek APRA approval to pay distributions and convert to shares on the optional or mandatory conversion dates
  • Distributions can be deferred and foregone altogether, there is no government guarantee
  • Capital Notes, while issued by the largest and most well-respected banks are much more risky than deposits in the same institution
  • New DDO regulation means that for many new financial institution capital notes, investors have to qualify as ‘wholesale’, making retail classified investors ‘ineligible’ to purchase the Capital Notes until the securities begin trading in the secondary market, even if they have been regular Capital Notes investors for many years
  • The securities assume investors can claim franking credits. Unlike shares, franking credits are included in the yields shown on the securities
  • Companies issuing Capital Notes usually specify a target value for a new issue raise. In the current, limited market, targets are exceeded frequently and companies often accept all applications. This reduces the opportunity for capital gains when the securities begin trading on the ASX.
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Elizabeth Moran
Editorial Director
Elizabeth is a nationally-recognised independent expert on fixed income. She has more than 25 years experience in banking and financial institutions in Australia and the UK and has been published in every major Australian newspaper and investment website. Prior to becoming an independent commentator in 2019 she spent more than 10 years as the head of education and research at fixed income broker FIIG Securities. Prior to joining FIIG, Elizabeth worked as an Editor/Analyst for Rapid Ratings a quantitative credit rating agency. She also spent five years in London, three working as a credit rating analyst for NatWest Markets.