Possible $2.5bn tailwind to drive hybrid demand in 2017

Glenn Freeman  |  22/02/2017Text size  Decrease  Increase  |  

Glenn Freeman: I'm Glenn Freeman for Morningstar and I'm joined today by Morningstar senior credit analyst, John Likos.

John, thanks for joining us today.

John Likos: It's good to be here.

Freeman: Just firstly John, what's your outlook for Australia's hybrid sector for 2017?

Likos: Yeah sure. Look I think this year we have a range of technical factors which should support hybrid pricing. By technical factors I'm largely referring to supply issues.

We've already seen a couple of issuers come to market and not replace their hybrids in the last few months. So we've seen Woolworths, we've seen Origin and we believe we're probably going to see some other issuers do the same thing through this year and they include companies such as Caltex, possibly Goodman as well.

There is a possibility that one of the major banks might not replace their listed security with another listed security they might replace it in the wholesale market and I'm referring to the ANZ HA there. So, if that’s the case than we are going to see a significant amount of money on the sidelines waiting for opportunities in this space.

So, we've calculated approximately $2.5 billion worth of money might be sitting on the sidelines after issuers called their notes without replacing them. And the ANZ note lifts that up to just over $4 billion.

We think that will be strong technical tailwind of course that won’t count for much if the market and the economic backdrop fall away and offset that.

But that’s not our base case scenario we continue to think the economy will continue to perform at a reasonable rate of growth. Which should, in line of the supply issues as well, provide a reasonable backdrop for hybrids. However, saying that I don’t think we're going to see the rapid price appreciation as we witnessed in late 2016.

Freeman: Can you talk a little about National Australia Bank's recent hybrid issue and why we supported this?

Likos: Yeah, absolutely. NAB came to market and issued the NAB subordinated notes too.

Now, they are a Tier 2 product. So, they are not like the Tier 1 hybrids that the market is generally more familiar with. The Tier 2 has more bond like features. For example, it doesn’t have a capital trigger whereas the Tier 1 securities do have a capital trigger.

And what a capital trigger is, basically, should the common equity Tier 1 ratio drop below a certain level, then they effectively have to be converted into equity and these don’t have that. They do have however the non-viability trigger as the new AT1s do.

However, in saying that, they also have event of default provisions which is much more bond like, meaning that you can't miss a payment without that, meaning a default for the issuer.

Whereas the AT1s, the more common ones, you can defer your distributions if you like even though there's a dividend stopper. There are, more bond like features we believe adds significantly to the quality of investor's portfolios by stabilizing a large part of it. It is far less volatile in a down market then what we'll find the AT1s will be.

So, look, we really like the product and we thought the price was fair, you'd always like a little bit more, but we still thought the price was fair where it was and we had no hesitation in recommending that for our investors.

Freeman: And John, do you expect some of the other major Australian banks will follow suit with issues this year. What are some of the risks that investors need to be mindful of if this is the case?

Likos: We do expect further issuance this year. When there is a note that’s due to be called or maturing, generally speaking, you'll expect the issuer to reissue.

So, we do have a couple of notes that are due to be called this year and that includes the Colonial notes, also some of the ANZ notes as well. So we think there will be replacement trades in that space.

The interesting one of course is the ANZ HA, that is a Tier 2 product. Now whether or not ANZ opts to come back into the list of market with that, or whether they opt to go into the wholesale market, I really think that’s a 50-50 play at the moment, which goes back to the supply driver that I mentioned before. But nevertheless, we do expect to continue to see the banks tap into this hybrid market.

In terms of risks, look there is always risk, and the biggest risk with hybrids is not understanding what you are buying.

So, we need to always ensure that investors are aware of what they are buying and they are aware of key terms such as the non-viability trigger and the capital trigger.

So, that’s critical now those triggers go back to the capital levels of the banks and therefore for hybrid owners you find that the greatest risks are related to issues surrounding capital levels.
Banks are very well capitalised at the moment, and we believe they'll continue to be well capitalised. But should there be any shock to the system whether it’s a housing related shock, whether it's a US-influenced shock in funding costs. It could well impact some of their bottom line capital numbers, which could then flow onto the pricing in the hybrid products.

Again, that’s not a base case scenario but these are issues that investors must continuously be on top of.

Freeman: John, thanks very much for your time today.

Likos: Thank you.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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