Challenger’s shortest dated hybrid, the $345 million Challenger Capital Notes (ASX: CGFPA), which has its call or repayment date coming up on 25 May 2020, has been trading very poorly at a price of $89.38 or a trading margin of 88 per cent or 8,800 basis points (bps) above the bank bill swap rate (BBSW), because of widespread concerns it would not be called and would be automatically converted into Challenger equity on its mandatory conversion date of 25 May 2022.

Challenger’s longer dated hybrid, CGFPB, has likewise been trading poorly at a price of $72.20 and a margin of 16.18% (1,618bps) above BBSW.

In the last month two banks, NAB and Macquarie, have cancelled proposed new hybrid issues because of the extreme volatility in financial markets that has pushed five-year major bank hybrid spreads to as high as 7.8 per cent (780bps) above BBSW

Previously, it was assumed that if Challenger did not call the CGFPA hybrid in May this year, it was left with no choice but to have the security mandatorily convert into equity in 2022. The risk of this happening is why it has been trading so far below its $100 face value.

In an ASX announcement today, Challenger revealed that it had negotiated with its regulator, APRA, the ability to call, or repay, CGFPA on any quarterly distribution date after its May 2020 call date, and committed to doing so.

Challenger announced that it intended to call and replace the CGFPA with a new hybrid issue as soon as market conditions normalise. Specifically, Challenger said that it “notes that other issuers have recently withdrawn offers of similar instruments because of the unprecedented market disruption and the inability to price such an offer in the absence of an orderly market”.

Challenger said it “has requested, and APRA has confirmed no objection to, Challenger having the right to…repurchase the Challenger Capital Notes for their full face value ($100) on any future Distribution Payment Date”.

Challenger’s chairman, Peter Polson, declared that “Challenger intends to launch a replacement offer with the proceeds used to repay the Notes at a future date”. Polson said “a key priority in making this decision has been providing noteholders with additional potential opportunities for the Notes to be fully repaid” rather than converting into equity.

The question for investors is what credit spread do they require until Challenger calls CGFPA. Assuming Challenger seeks to do so over the next 12 to 18 months, one can use the current Westpac hybrid WBCPF, due to be repaid on 22 March 2021, as a benchmark.

WBCPF is trading at 5.5% above BBSW based on its price of $98.73. Challenger Group’s Additional Tier 1 hybrid securities have an implied shadow credit rating of BB, which is two notches below Westpac’s investment-grade BBB- rating on its hybrid securities.

Macquarie Group’s hybrid MQGPB has a similar implied BB shadow rating as Challenger, an almost identical call date to WBCPF, and trades on a credit spread of about 2.8% (or 280bps) points above WBCPF’s spread.

Assume conservatively that CGFPA trades on a much wider credit spread of say, 5% (500bps) above the majors’ hybrids (or almost double Macquarie’s spread), which gives a total credit spread of 10.5% (or 1050bps) above BBSW.

Assume further that Challenger calls CGFPA in 12 or 18 months' time.

This implies a current fair value for CGFPA of between $92.93 (12 months) and $89.91 (18 months).

Challenger further revealed today that it has secured the ability to increase its common equity tier one capital ratio by $250 million. Its current CET1 ratio is at the top end of its target band.

Challenger has also recently substantially reduced its portfolio exposures to equities and high yield bonds.