Why bank hybrids are dented not smashed

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Standard & Poor's downgrade of Australia's major bank-issued subordinated and hybrid securities last month was a negative but not a deal-breaker for experienced, well-informed retail investors.

Australia's "big four" banks themselves were spared a downgrade, with ANZ (ASX: ANZ), Commonwealth Bank (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac (ASX: WBC) each maintaining their AA-minus rating.

S&P considers that major bank subordinated and hybrid securities would likely not be supported by the Government in the event of a default, a view shared by Morningstar's senior credit analyst, John Likos.

"Previously rated investment grade, they were downgraded one notch to non-investment grade. This had a minor impact on pricing after some mandate restrictions required some selling, but not too much given most of these securities continue to be held by retail investors," he says.

Likos emphasises that the re-rating of stand-alone credit profiles "had no impact on our risk assessment of financial institution-related hybrids under our coverage. Morningstar makes its own assessment of such risk and our view remains unchanged."

"Furthermore, we continue to be encouraged by increasing regulatory initiatives to maintain the strong capital levels of domestic financial institutions. The rating agency continues to view the outlook for the Australian banking sector as relatively benign by global standards," he says.

Be alert, not alarmed

Some commentators suggest the latest ratings call should warn retail investors away from bank hybrids, given their loss-absorption characteristics and subordination within the capital structure.

For example, capital notes issued by a bank which qualify as regulatory capital under the latest Basel-III prudential requirements may either convert into ordinary shares, possibly worth significantly less than the original investment, or be written off completely under certain conditions. In the event of a wind-up scenario, the recovery rate on hybrid securities will be materially lower than for securities above them in the capital structure--such as traditional fixed income.

However, they have a significantly better recovery rate than securities lower in the capital structure, such as equities, and Morningstar moat-rated hybrids in particular should continue to appeal to retail investors, as part of a stable income investment strategy.

"Investors should always understand the capital structure positioning of their investments, as part of their investment due diligence process," Likos says.

Morningstar subscribers receive regular analysis on Australian hybrid issuances, along with access to the new Hybrids Guide.

Exhibit 1 Basic capital structure framework

Source: Morningstar.

Likos also emphasises that the capital structure positioning of a security-type is not a hard-and-fast rule.

"It is not uncommon for a security that sits lower on the capital structure of a stronger issuer to have lower credit risk, relative to a security that sits higher on the capital structure of a weaker issuer.

"This highlights the importance of understanding the standalone risk of the issuer… [with banks being] a good example of an industry that can display complex capital structures due to regulatory requirements.

The below chart shows the relative price performance of Commonwealth Bank’s equity, AT1 hybrid securities and senior unsecured debt during the global financial crisis.

Exhibit 2 Relative performance of various Commonwealth Bank securities during the Global Financial Crisis

Source: Thomson Reuters, Morningstar.

Hybrid securities can diversify the overall risk of a portfolio while generating attractive returns, thereby improving overall risk-return profiles. However, Likos again emphasises that they "should not be considered a like-for-like replacement for term deposits or pure debt."

"We believe they should be viewed as a separate asset class with their own asset allocation, to fully benefit from diversification benefits."

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Glenn Freeman is a senior editor at Morningstar.

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