What are bank hybrid securities and what purpose do they serve?
There are 3 types of bank hybrid securities:
- Capital notes;
- Convertible preference shares; and
- Subordinated notes.
These products are designed to be loss-absorbing products that provide a layer of security for the bank’s depositors at the expense of the hybrid investors.
If the bank experiences financial difficulty, bank hybrids can be converted into bank shares. These may be worth less than the initial investment, or even written off completely, meaning the investor some or all of their capital.
Hybrids vs Government bonds (ie traditional defensive assets)
In summary, hybrids are different from government bonds because hybrids can be redeemed at any time prior to the maturity date at the discretion of the company. Hybrids have more volatility on the market, are is considered equity on the company’s books and may result in a capital loss in the event of early redemption.
It’s a mistaken belief that all hybrids provide a secure income stream. Most income provided by hybrid assets are discretionary and have a non-cumulative distribution. This means that the holding company has no obligation to declare dividend payments to its investors and have no further obligation to make the distribution in arrears. Therefore, if the company decides to skip a dividend payment, it has no obligation to preference its initial investors to the current investors.
In contrast, government exchange traded bonds have a secure level of income that can be calculated: see Bond calculator.
If we accept the proposition that every income generating asset that’s ‘relatively stable’ and provides ‘considerable income’, then REITs may very well also be considered a defensive asset since it would be superior to a hybrid asset and have a comparable income return. At minimum, REITs have physical assets as compared to hybrids that are not considered in the books of the holding company.
Therefore, income generated from an investment should not be a factor in determining whether a product is defensive or growth.
As mentioned, bank securities have the potential of being converted into bank shares at the discretion of the banks. This conversion might not be beneficial to the investor when the market is going down because the inherent nature of a defensive asset is to provide security of capital in a bearish market.
In contrast, traditional defensive assets like a term deposit or bond provides certainty in the capital and are less likely to have their capital decrease during a bearish market. However, do note that these bonds do not have absolute capital security. You may refer to the risks of such bonds here.
Does rising interest rates mean that bond holders lose capital?
The answer to that is both Yes and No.
In what situation does a bond holder lose capital value with the rise in interest rates?
The diagram above shows the correlation between interest rates and bond prices
Assuming an investor purchases a Treasury Bond (TB,GSBK39) at a coupon rate of 3.250% at a price of $121.75 in 2017, you will be receiving that 3.250% till its maturity date in 2039. This rate is fixed regardless of the fluctuation of interest rates. However, assuming that the interest rates increases in 2018 by 1%, then the value of this TB will decrease because there will be a higher coupon interest rate that matches that increased interest rate. A drop in the demand in GSBK39 will mean that it’s less likely a new bond investor would purchase GSBK39 for $121.75 and the bond holder will lose capital value if they decide to sell their bond prior to its maturity date.
How then does the bond holder NOT lose its capital?
A bond holder will NOT lose its capital if its’ held to its maturity because regardless of the fluctuations in interest rates, the coupon interest rates are fixed and the face value of the TB remains at $100 face value (please note that this refers to TBs and NOT TIBs). Bonds are not meant to be speculated and should be held to maturity to avoid any potential capital loss from the fluctuation in bond prices. As an example, assuming the investor holds GSBK39 to its maturity, the fluctuation in interest rates have no impact on the bond holder who will receive 2.021% return on that investment at the end of the maturity in 2039. What will happen to the yield, in the event of an increase in interest rates, is that the yield of the bond will increase as well. This is not the result of the change to the coupon interest rates but the price of GSBK39 will decrease, for reasons mentioned above.
Therefore, it would be incorrect to assert and conclude that bonds are not defensive assets because they will result from capital loss. The capital loss is a result of the investor’s decision making, rather than the result of the financial product (ie the TB). As illustrated above, if the TB was held to its maturity, there will be no capital loss suffered.
Underlying asset type and face value of the hybrid security
During a conversion, hybrid securities do not necessarily convert dollar for dollar with a bank share. This conversion is affected by a few factors and we suggest you read the PDS or prospectus of your recommendation prior to the recommendation.
Using Westpac’s capital note as an example, they have the following fomular: Maximum Conversion Number = Face Value / (Relevant Percentage x Issue Date VWA). Relevant Percentage means: based on the conversion date, it might either be 0.50 or 0.20. Therefore, it’s not necessarily $1 capital note = $1 Westpac shares.
If we take Westpac Capital Notes 4 (WBCPG) at today’s value of $105.96, assume that a trigger event occurs today and consider the fact that it will be redeemed on 20 December 2023 (or earlier), WBCPG will convert into Westpac ordinary shares worth $101.01 at 1% discount because of the face value of the capital note at $100. This means that the client who purchased today and gets the capital note redeemed tomorrow will have made a $3.99 loss, something that was unexpected because the redemption was at the discretion of the company.
Critically, Hybrids is considered equity and doesn’t count towards the debt of the corporate balance sheet (unlike bonds, which gets noted as a debt by the government to the bond holder)
What happens to Hybrids in the event of a bearish market?
The recent collapsed of the Spanish bank, Banco Popular Español, shows the risks associated with Hybrids. Earlier this month, the Spanish bank wrote off all Tier 1 Hybrids (ie investors were left with zero) and the Tier 2 subordinate debts were converted into equity (which also equates to zero value since the bank was bought over by Banco Santander for one Euro). Had the clients relied heavily on Hybrids as their defensives assets, they would have lost a substantial portion of their capital because it would have been written off totally.
Therefore, the adviser who propositioned their clients that these are defensive assets would have a hard time explaining why their clients no longer have these funds because they have effectively been written off.
In summary, Hybrids are neither identical to Growth nor Defensive assets due to its unique characteristics. The inherent nature of its own classification would support that proposition. However, for the purposes of financial planning, categorizing it as a Growth asset is more appropriate based on the discussion above because it shares more characteristics to a traditionally Growth asset.
Mandatory wording when recommending Hybrids
- Hybrid securities are complex products. Many experienced investors struggle to understand the risks associated in trading them. You should only invest in hybrid securities if you fully understand them. In addition to the reputation of the issuing company, you need to consider underlying product and its associated risk.
- Hybrid securities are not ‘traditional’ corporate bonds. They are different to traditional fixed income investments. Interest payments may be deferred and capital may not be repaid for periods of several years. All payments are at the discretion of the issuer and the investor (yourself) may be issued with shares rather than a return of capital. These factors are all outside the control of the investor. Accordingly, these products may not be suitable if you require steady returns and capital security.
Moneysmart has a great summary of differences between Hybrids and other investments. For your convenience, they are as follows:
- Shares -You may receive dividends which are paid at the company’s discretion. They do not accumulate if not paid.
- Capital notes – You may receive distributions based on a set formula, but these are at the bank’s discretion and do not accumulate if unpaid. If the bank does not pay distributions on capital notes it can’t pay dividends on its ordinary shares.
- Subordinated notes -You are entitled to receive interest payments based on a set formula. Interest may be deferred (and accumulate) for up to 5 years depending on the issuing company’s financial position.
- Corporate bonds – You will receive interest payments that are either fixed or based on a set formula.
- Term deposits – You will receive interest payments based on a fixed rate.
Investment timeframe and redemption
- Shares – Shares have no maturity date, and are never required to be repaid.
- Capital notes – Fixed period of generally 8-10 years. They are designed to convert into ordinary shares, however if the bank meets certain conditions, it may choose to repay the capital notes in cash.
- Subordinated notes – Fixed term of up to 60 years from the date of issue. You will be repaid in cash at maturity.
- Corporate bonds – Fixed term, usually between 5 and 10 years from the date of issue. You will be repaid in cash at maturity.
- Term deposits – Fixed term, usually between 1 month and 5 years. You will be repaid in cash at maturity.
Early repayment at the issuer’s discretion
- Shares – No.
- Capital notes – Yes, subject to certain conditions and regulatory approvals after 5 or 6 years, or at any time if a relevant trigger event occurs. You may be issued with ordinary shares in the bank instead of cash.
- Subordinated notes – Yes, on fixed dates usually beginning 5 years after the note was issued, or at any time if a relevant trigger event occurs.
- Corporate bonds – Yes, but only in limited circumstances.
- Term deposits – No.
Early repayment at the investor’s discretion
- Shares -Yes, listed shares can be sold on a stock exchange at the current market price.
- Capital notes, subordinated notes and corporate bonds – These investments are usually listed and can be sold at the current market price, subject to market liquidity. This could mean that if you need to sell your investment in a hurry, you may have to accept a lower price if there are fewer buyers in the market.
- Term deposits – Yes, although you may forfeit some or all of the accrued interest.
- Shares – If there are any assets left after repaying all banks, lenders and bondholders, shareholders divide up what is left, but they are the last in line.
- Capital notes – Before the bank becomes insolvent, a ‘loss absorption’ or ‘non-viability’ event will occur. Your capital notes will either convert into ordinary shares in the bank, which may be worth significantly less than your original investment, or be written off completely.
- Subordinated notes – If there is anything left after bank lenders, senior and secured creditors and other bondholders have been repaid, you may get some or all of your investment back.
- Corporate bonds – If there are any assets left after bank lenders, senior and secured creditors are repaid, you are the next in line to be repaid some or all of your investment, ahead of any subordinated note holders.
- Term deposits – Term deposits placed in an Authorised Deposit-taking Institution of up to $250,000, are guaranteed by the Government. This cap applies per person and per ADI.