Most investors have polarised portfolios bifurcated between cash deposits and equities. Few appreciate that these two very different securities span a rich corporate capital structure that allows for a much more continuous distribution of risk and return experiences.
One powerful illustration of this point is the recent financial market turbulence, which has unearthed some fascinating opportunities across the cash deposits, senior bonds, subordinated bonds and hybrids issued by the major banks.
Let’s deal with each in turn. The hybrid market has been hammered by a number of technical, or non-fundamental, shocks since late January 2018. First, Westpac and then CBA both announced large number hybrid deals (WBCPH and CBAPG respectively).
Over $3.1bn of New Hybrid Supply
It is quite unusual to have two major bank hybrids launched at effectively the same time, and we explicitly warned CBA about following Westpac so closely. In total, the two major banks have flooded the ASX with over $3.1 billion of new hybrid supply over February and March.
When Westpac officially launched WBCPH in early February we wrote that fair value for this security with no “new issue concession” was a spread of 3.43 per cent above the 3 month bank bill swap rate (BBSW) based on the spreads offered by similar major bank hybrids trading on the ASX at the time.
We would normally expect a minimum of 0.2 per cent (or 20 basis points) in extra spread as a new issue concession, or a total trading margin of about 3.6 per cent above BBSW. Rightly or wrongly, Westpac chose to issue almost $1.7 billion of hybrids at an incredibly tight spread of just 3.2 per cent above BBSW, or 0.23 per cent less than the fair value margin assuming no new issue concession.
Today WBCPH is unsurprisingly trading poorly, bid at $96.90 on 26 March, which translates into a 3 per cent plus capital loss for the original investors in the issue.
New Hybrid Margins Too Skinny
CBA offered a 3.4 per cent margin above BBSW for its new CBAPG security, which was the secondary market fair value on the same day that Westpac launched in early February. The problem is that the effect of bringing $3 billion plus of new hybrid supply to market blew-out this fair value margin to 3.5 per cent on 2 March before one accounts for any new issue concession (ie, 3.7 per cent including one).
With Westpac and CBA both paying brokers and advisers sales commissions of 0.75 per cent on the new deals to push them, we have seen enormous churn, or selling, of older existing hybrids paying superior spreads (or returns) to the new securities.
This temporary dislocation has been amplified by Bill Shorten’s sudden announcement in mid March that Labor would ban cash rebates on franking credits (notably not franking credits themselves). While the policy does not affect more than 92 per cent of all taxpayers, and Labor has subsequently diluted it down very materially by expressly excluding all pensioners and part-pensioners (over 300,000 retirees), including pensioners in self-managed super funds, the knee-jerk reaction on the day of the news was savage with hybrid prices falling over 0.4 per cent.
The reality is that both parties have confirmed their support for the franking system, which is a win for investors, and anyone who happens to not be able to fully use franking credits will be selling to buyers who can price them in.
Hybrid Cash Yields Over 4%
Even excluding all franking credits, major bank hybrids like CBAPD are paying a very attractive, 2.38 per cent cash spread above 3 month BBSW, which means it is offering an all-in cash return of 4.38 per cent for a BB+ rated security that has much better liquidity than other Australian sub-investment grade bonds.
With franking CBAPD’s spread above BBSW jumps to 3.87 per cent, which represents a total yield to maturity of 5.87 per cent (see the first chart). Put differently, cash returns on hybrids today are significantly above anything else that investors can switch into with comparable risk. For the 9.5 out of 10 people that can still use franking credits if Labor wins the election, and the pensioners that can still get cash rebates, the fully franked yields are in the order of 5.5 per cent to 6.1 per cent per annum.
ASX Hybrid Supply to Shrink
We believe that the stock of ASX hybrids will shrink over time as the major banks shift some of their issuance to the deeper US dollar market, as ANZ, Westpac and Macquarie have recently done. And we think that there will likely be unlisted issues of major bank hybrids to institutional investors in the Aussie dollar over-the-counter market in the years ahead, which will collectively combine to create a shortage of ASX supply.
Whereas 5 year major bank hybrids were paying spreads of about 3.0 per cent above BBSW in January, this has now blown-out to 3.81 per cent as at 26 March, which is about 1.45 per cent (or 145 basis points) above the mid 2014 “tights” of circa 2.36 per cent above BBSW even though the major banks have massively increased their common equity tier 1 (CET1) capital ratios from around 8 per cent in mid 2014 to circa 10.5 per cent today. This increase in CET1 capital is important because it directly reduces the risk of the hybrids being automatically converted into bank shares, which occurs when the CET1 ratio falls to 5.125 per cent.
Hybrids Much More Attractive than Subordinated Bonds
The unusually attractive trading opportunity associated with major bank hybrids is highlighted by the second chart, which examines the historical ratio of 5 year major bank hybrids over 4 year major bank Tier 2 subordinated bonds (we use the 4 year maturity because there are more securities to sample from). It also compares 4 year subordinated bonds to 5 year major bank senior bonds.
Since 2012 both ratios have tended to oscillate around a 2 times multiple until late 2017 when subordinated bond spreads compressed further than hybrids and major bank senior bonds. But the real break has been seen in 2018 where the ratio of major bank hybrid to subordinated bond spreads has exploded to its highest level ever of 2.9 times. At the same time, the ratio of subordinated to senior bond spreads has also fallen to its lowest level ever at 1.4 times.
As there are no credit events affecting major bank paper—as borne out by the strength of the riskier subordinated bond securities and only marginal increases in the major banks’ 5 year credit default swap spreads—it is likely that hybrids and senior bonds have been impacted by one-off “technical events” that should normalise over time.
Major Bank Senior
Normally among the safest and lowest risk assets one can hold outside of cash, the major banks' AA- rated senior-ranking floating-rate notes (FRNs) have gapped some 26 basis points wider in spread terms since January 2018. Specifically, the bid for 5 year major bank senior FRNs has jumped from 0.74 per cent over the 3 month BBSW to around 1.0 per cent over, which has in turn reduced the clean price of these bonds by almost 1 percentage point.
After a massive increase in major bank senior spreads over late 2015 and early 2016, which was subsequently reversed, this is the biggest spread widening in major bank senior bonds since 2012. However, it does not appear to be driven primarily by credit related concerns as was the case in 2015 and 2016. This is borne out by the fact that major banks' subordinated bonds are behaving like they are safer than senior debt. In 2015/2016 the blow-out in major bank subordinated bond spreads was 1.5 times to 2 times more than the increase in senior spreads.
Banks Selling to Boost LCRs
So what is going on? We understand US companies have been pulling their cash deposits out of Australia and sending the money back to the US following recent tax changes made by President Trump to encourage the repatriation of capital. This has left Aussie banks with lower than normal amounts of cash on their balance-sheets. Three of the four major banks (all except CBA) have half-year reporting dates on 31 March while Bank of Queensland has its half year balance date on 28 February.
Market participants report that over the last month or two these banks have been selling their holdings of major bank senior bonds, which are among the most liquid assets (ie, easy to both sell and buy-back), to improve their cash ratios coming into their half-year ends. Specifically, they want to boost their "liquidity coverage ratios" (LCRs).
At the same time, an important buyer in the market in the form of Japanese banks, life insurance companies and asset managers have temporarily disappeared because all Japanese institutions have their full financial year balance dates on 31 March. Market participants suggest that these Japanese investors ordinarily withdraw from the market in the final month of their financial year, returning again in April.
Cash Rates Spike
The jump in 5 year major bank senior spreads has been significantly amplified by a very large increase in the 3 month bank bill swap rate from 25 basis points above the RBA's 1.5 per cent cash rate (or 1.75 per cent in total) to 50 basis points above cash, or 2 per cent today. This has likewise been driven by non-fundamental factors.
Specifically, an increase in short-term US government debt issuance has pushed all short-term money market interest rates higher. This has been accentuated by changes in US regulations in 2016 that encouraged US money market funds to shift their capital from short-term bank paper to government bonds, which has created a scarcity of short-term funding.
It would, however, be very unusual for BBSW to remain at 50 basis points above the RBA cash rate, and these spikes have always normalised historically. Until BBSW mean-reverts, investors in major bank senior FRNs can potentially get an extra 51 basis points of return (26 basis points from major bank senior spreads and the 25 basis points via BBSW).
A final influence on these interest rates has been the general widening in credit spreads globally, although the major banks' senior bonds have widened more than similar senior "opco" or operational company (as opposed to holding company) bonds in the US and Europe with significantly lower credit ratings than the majors' AA- level. This has undoubtedly exacerbated the major bank move.
The offshore move has not been driven by any empirical deterioration in credit fundamentals—with global growth improving and wages and inflation still benign. The move wider in spreads has been mostly explained by technical factors, including the jump in short-term bank bill rates coupled with a surge in supply or bond issuance prior to the summer holiday break in the northern hemisphere.
This is reinforced by the fact that before the Trump “tape bomb” regarding the possibility of a trade war last week, US equities had fully recovered their February losses.
The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.