Battle between equity and debt...

Christopher Joye

Coolabah Capital

In the AFR I discuss the bifurcation between equity and debt, the major banks' funding needs, NAB's unique approach to integrating trading and sales up and down the capital structure, and prospective rating changes for bank subordinated bonds and hybrids (click here to read for free or AFR subs can click here). Excerpt only:

One of the challenges investors face is the traditional bifurcation between equity and debt even though they are often just different pieces of the same corporate entity.

In many portfolios fixed-income and equity allocations are evaluated separately given they are assumed to derive from independent asset-classes.

And at the funds management level there tends to be little, if any, interaction between folks running stocks and bonds.

What makes this somewhat surprising is that within a given company the value of equity and debt are often highly intertwined.

When the four major banks were levered 28 times in 2014, it was not hard for them to punch out 18 per cent returns on equity.

Yet as the regulator forced them to lower their (non-risk-weighted) balance-sheet leverage to 17 times today, equity returns have slumped by one third.

Moving one-notch up the capital structure, a different story has played out.

The banks' hybrid securities are automatically converted into ordinary shares if their (risk-weighted) common equity tier 1 (CET1) capital ratios fall to 5.125 per cent.

There was, therefore, a much higher probability of this happening in 2014 when ANZ's CET1 ratio was only 8.3 per cent compared to the 11.0 per cent ratio it reports today. While lower leverage can be negative for equity, it is normally a significant positive for debt.

Financial institutions generally do a terrible job of offering integrated capital structure solutions for clients. If you are a CommSec customer you can buy ANZ equities and hybrids, but not, ironically, the safer securities sitting higher-up ANZ's capital structure, such as its unlisted subordinated notes, senior unsecured bonds, secured covered bonds, and/or asset-backed securities.

The one exception I know of is NAB, which has done an impressive job unifying capital structures for its clients from both a sales and trading perspective.

My fixed-income sales person offers me listed equity funds and hybrids combined with the full spectrum of over-the-counter bonds. And he is backed by a trading floor that for the first time in Australian history includes market-makers covering the entire gamut of listed hybrid and unlisted debt securities.

It is a revolutionary organisational approach that explains why NAB's traditionally fixed-income orientated markets business, run by Drew Bradford, has emerged as the leading player in the lucrative new issue market for listed investment companies running debt and equity strategies.

It also necessitates the integration of the otherwise disparate sales channels covering the retail, high net worth, mid-market, corporate, and institutional markets.

Thinking about the entire capital structure affords access to unique insights.

Equity hedge funds and sell-side analysts have, for example, been arguing of late that the major banks are suffering from a significant reduction in deposit growth, which, they claim, has created an enormous "funding gap" that will be costly to fill, pressuring net interest margins and profits.

In the same vein, large offshore investors have been trying to focus attention on the sharp deceleration in Australian money supply growth, which is sitting at its weakest level since the 1991 recession. This is supposed to be a harbinger of doom.

And yet when the major banks' treasurers engage with their creditors, they paint a very different picture.

First, the banks feel they are awash with funding—they actually have too much cash. CBA recently announced a buy-back of $8.8 billion of its bonds precisely to reduce excess liabilities.

Second, deposit growth is actually strong, not weak, as CBA reported this week: the deposit share of its funding base rose from 67 per cent to 68 per cent over the 2018 financial year.

Indeed, CBA has experienced explosive growth in low-cost transaction accounts, which have jumped almost 11 per cent over this period.

The major banks are full on funding because asset growth has been lower than they expected.

According to the RBA, the total value of loans on bank balance-sheets has expanded at an average annual 8.1 per cent pace since 2007. Yet over the last 12 months this has slumped to 4.6 per cent as tighter lending standards have gripped.

This is almost certainly less than what bank treasurers were forecasting when they started the 2018 financial year, which means they grew their liabilities (deposits and bonds) a little too fast.

This was again borne out in CBA's results, which revealed that its household deposit growth of 4.2 per cent had outstripped the 3.7 per cent increase in the value of its home loans.

As an aside here, one of the reasons it is mathematically hard to get negative housing credit growth—as hedge funds and UBS's Jon Mott have forecast—is because pre-payments slow-down sharply as interest serviceability becomes more difficult, which offsets the reduction in new originations.

Properly understanding balance-sheet dynamics also sheds light on Australia's languid money supply growth…

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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