Is It a Good Time to Buy Hybrids?

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Macquarie Bank’s new hybrid with an attractive margin of 4.7% over 3 month bank BBSW, begs the question – is it a good time to buy hybrids?

Current trading margins on hybrids average around 4.4% per annum but spiked at over 7% recently. Before CONVID-19, margins were significantly lower.

Current yields are attractive given very low deposit rates, but the wider margins reflect elevated risk. The banks themselves are gearing up for inflated credit losses, adding billions to provisions in their latest interim accounts.

Even though medically Australia may be over the worst of the health crisis and there is much to be hopeful about, I am not convinced the banks are through the worst of the ensuing economic crisis.

For the half year ending 31 March 2020, ANZ and Westpac both decided to defer decisions on interim dividends, after the bank regulator, APRA encouraged banks to consider capital positions before paying dividends. Non payment of dividends opens the door for the banks to consider cutting hybrid income distributions.

Hybrids are ‘loss absorbing’ instruments and issued as regulatory capital to support the survivability of the issuing financial institution. In stressed markets, they are designed to take some of the pain.

For example, hybrid distributions can be cut and never have to be made up at a later date.

Hybrids can also convert to higher risk shares if bank capital falls below 5.125 per cent or APRA deems the institution ‘non viable’. So, while they pay regular income at attractive yields, they can also convert to shares at the worst possible time.

Income investors who rely on income and franking credits need to be aware of these characteristics.

One of the terms and conditions that gives hybrid investors comfort is the ‘dividend stopper clause’. If financial institutions decide to stop making hybrid distributions, then they can no longer pay dividends on shares.

If the bank has already stopped paying dividends, then there is less incentive to keep making hybrid income payments.

Except, of course, investors have long memories and banks need to look after investors for the long haul.

Another factor in payment of hybrid distributions is the financial institution regulator, APRA. It needs to look after the financial safety of institutions and the stability of the Australian financial system, so has the capacity to object to hybrid distributions when capital is better retained within the bank.

It has always been possible for hybrid distributions to be cut and while risks are heightened, I think it’s unlikely, especially for the four major banks. Time will tell, the risks exist and it’s always better to understand the downside than be caught like a hare in the spotlight.

 

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Elizabeth Moran
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.

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