Today I write that the ASX hybrid market has had a huge rally as a result of the election, with a market-capitalisation weighted index of bank hybrids returning a stunning 8.8 per cent (including franking) over the year to 19 June (click on that link to read the full column or AFR subs can read here). In the last month alone, the ASX bank hybrid market has jumped 2.6 per cent as the risk premium, or credit spread, demanded by investors on a typical 5 year major bank hybrid has crunched in from 3.56 per cent above the quarterly bank bill swap rate (BBSW) to just 2.95 per cent above BBSW. (BBSW is currently 1.26 per cent.) There was much chatter around the punter who bet $1 million on Labor to win. We shifted more than $100 million into fully-franked hybrids just before the poll on the assumption ScoMo would win, or, if he did not, Labor would slip over the line and face a Senate staunchly opposed to their franking proposal. Excerpt enclosed:

A key question now is how much tighter credit spreads can go. The global credit market is actually akin to two quite different asset-classes: corporate bonds and bonds issued by so-called financials, which mainly encompass banks and insurers. I often hear the comment that “credit spreads look tight”. This is both wrong and right.

If you compare the credit spreads on bonds issued by non-financial corporates, it is true that they look awfully expensive. Irrespective of whether these are very low risk AA rated, lower risk BBB rated, or higher-risk BB rated bonds, their credit spreads today are remarkably back in line with levels prior to the 2008 crisis. And this is despite the fact that corporates have generally been increasing their leverage, which would normally demand higher, not lower, spreads.

The exact opposite finding applies, however, in the case of bonds issued by banks. It does not matter where you look across their capital structures, credit spreads are literally multiples of their pre-crisis levels. Taking the typical major bank, hybrid spreads are 2.4 times wider than 2007 marks. Tier 2 subordinated bonds spreads are 5.6 times larger. And, most astonishingly, the major banks’ safest, AA- rated senior bonds are paying credit spreads that are 10.1 times chunkier than what they offered in 2007.

This is even more surprising when you consider that banks have been radically deleveraging their balance-sheets since 2007, and generally de-risking their business models. More specifically, the major banks have halved their risk-weighted leverage, with their Tier 1 equity capital ratios jumping from 6.8 per cent in 2007 to 12.7 per cent today.

Read the full column here.

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