Wry & Dry

What's in a name. That which we call a bank hybrid by any other name would smell as sweet.

W&D always thought that a hybrid was something that Mrs W&D grew in the flourishing W&D garden.  A hybrid rose, for example.

RoseOne sort of hybrid

Of course, hybrid can mean any blend of two or more somethings to create a third something.  And so if a company issues a security that pays interest but can convert or be converted into equity, then that too is a hybrid.

Work with W&D on this.  

If a bank needs to raise capital to meet regulatory minimum capital requirements (so if things go wrong then we-the-taxpayer do not have to bail-out the bank) without diluting existing shareholders (if the bank issues more shares, then, given the same profit, profit per share goes down) then the bank can:

  1. issue bonds that pay a rate of interest, but
  2. if things go wrong, convert the bonds to equity (i.e. shares)

Everyone is a winner!

Err, no.

As bank deposit rates have fallen to record lows, billions of retail investment dollars have poured into these relatively high yielding hybrid securities issued by banks.  The investor is attracted to a yield paid by a bank that is much higher than bank deposit rates.

But hybrids are securities that are bought and sold on the ASX.  And hence have a price.  But most investors retail investors don't worry, or even know about, the market price.  The market price of a hybrid is determined by interest rates and the share price of the bank.

The share price of the bank is important as if the hybrids are converted into equity, then the investor gets shares.

So, having said that, W&D was drawn to a piece in the excellent Yield Report email*.  That article propounded that investors underestimate the risk in bank hybrid securities.  W&D has made noises about this for years, especially as retail investors seem to like investing in banks and bank hybrids, making a somewhat concentrated portfolio.  But that is a longer story.

The reason is that APRA, the government body that is the prudential regulator of Australian banks, has said that if a bank's capital falls below 8% of its assets, as measured by CET1 - Common Equity Tier 1**, then 40% of the banks profits must be withheld, and cannot be used to pay dividends, hybrid income payments, bonuses, etc.

The hybrid's yield goes OTD (out the door).

But, wait.  There's more.  If CET1 falls further, further restrictions apply.  To the point that the hybrids are forceably converted into shares.  This is called a bail-in.  

Consider the case of Lehman Brothers, as W&D described last week.  There, the assumed $100 of assets was matched by debt of $97 and equity of $3.  If the value of the assets fell to $97 the bank was wiped out, as there was still debt of $97 owing.

But if Lehman had issued, say $7 of hybrids, then $7 of hybrid debt would convert to $7 of equity#.  So debt would fall to $90, with equity (nominal) at $10.   The bank doesn't fail.  Buy hybrid investors are not happy. 

For the investor in the hybrid, the hybrid is not longer debt, it is equity.  The investor becomes a shareholder.  The conversion of the hybrid would be at the very time when an investor would want to not hold a bank share - as the reason for its CET1 falling would be the sort of events that would cause its share-price to collapse.

So what, W&D hears readers ask.  Well, there are two points:

Firstly, as Yield Report notes, and by reference to an academic paper, investors are not aware of the risk (albeit small) they are taking in investing in hybrids.

Secondly, banks will do whatever they can to ensure that their CET1 doesn't fall below 8%.  ANZ has a CET1 of 9.1%; Westpac 9.2%; CBA 10.6%; NAB 9.5%.  The margin is not large.  Hence the need to issue more and more capital, further diluting existing shareholders.

Readers might look to what is happening in Germany, where Deutsche Bank (Germany's largest bank) is struggling to survive.  Deutsche has issued a European version of a hybrid, called 'contingent convertible debt' or CoCo bonds.

The capital value of its CoCo bond has slid from 100 euro cents to 73 euro cents.   The fall in price is because investors are selling, fearing that the bond will be converted into Deutsche Bank shares.

The hybrid rose that investors smell may not smell as sweet as first thought.

*Yield Report is a weekly email, commenced by veteran and venerable asset consultant Ken Atchison.

**The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by APRA.

#Not quite, the conversion would be a discount.