Hybrid market turns as S&P flags upgrades

Christopher Joye

Coolabah Capital

In the AFR today I examine why the ASX hybrid market is once again booming and changes S&P announced this week to the way they are rating Aussie banks that could result in rating shifts for subordinated bonds and hybrids (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"Since March when the market had to absorb $3.1 billion of new Westpac and CBA hybrid supply (WBCPH and CBAPG), the Solactive ASX Hybrids Index has jumped 1.14 per cent (114 basis points) before franking. Over the same period, the Reserve Bank of Australia’s cash rate returned 31 basis points.

In the first two weeks of June, the Solactive Hybrids Index, which is a market capitalisation weighted benchmark of all ASX hybrids and subordinated bonds, is up 62 basis points before franking.

The sudden shift in the zeitgeist coincided with the 8 June listing of Macquarie’s $1 billion new hybrid (MQGPC), which is the first deal in 2018 to perform. It is currently trading above par at around $100.50, which means that the spread it pays above the quarterly bank bill swap rate (BBSW) has compressed from 400 basis points pre-listing to 394 basis points today.

MQGPC is actually the only new issue we have bought this year after dodging WBCPH, which is trading at $96.50, and CBAPG, which is also below par at $97.50.

Five year major bank hybrid spreads on the ASX had blown-out from 300 basis points above BBSW in January to 400 basis points in May, some 60 basis points higher than levels accepted by institutions buying the majors’ US dollar hybrids (swapped back into Australian dollars or 80 basis points higher in US dollar terms). At the same time, the BBSW rate has leapt 30 basis points from 1.75 per cent to 2.05 per cent, boosting overall yields to levels not seen since 2016.

In fact, CBA’s hybrid spreads are now 4 times larger than what the bank paid on its Perls IV security in 2007 notwithstanding its vastly improved risk-weighted capital ratios.

So why the sharp turn-around? Beyond being the sole deal to price with a modest concession (extra margin) to what were already handsome secondary spreads, MQGPC carried the distinction of paying by far the largest cash yield (pre-franking) to its expected maturity of 5.65 per cent (that's 4.2 per cent above the RBA cash rate).

The three major bank hybrids due to be called within 10 months of MQGPC (ANZPH, CBAPG, and WBCPH) offer cash yields of 4.6 per cent to 4.8 per cent, which while 3.3 per cent above the cash rate are inferior to MQGPC. Including franking, MQGPC’s 6.5 per cent yield is similar to the best major bank hybrids, which are about 100 basis points higher than the franked dividend yield on the ASX200 index.

A second tail-wind is the fact that the surge in hybrid supply appears to be behind us with only one major bank issue expected over the remainder of 2018, which will be used to refinance the CBAPC security that should be called in December. (CBA deliberately put a December—rather than September—call date on CBAPC to give itself more time to roll later in the year.)

After raising $1.37 billion of entirely new money via the poorly timed CBAPG in March, it is likely any new deal to replace the $2 billion CBAPC will be comprised primarily of rolls from existing holders. (Macquarie’s MQGPC reported an unusually high roll rate of circa 70 per cent, which augurs well for CBAPC.)

CBA is selling its funds management business this year, and will likely head into 2019 sitting on significant excess equity. If it needs any more hybrid money, it has the option of issuing a small unlisted offering next year as three regional banks have previously done (there are only two major bank hybrid maturities in 2019).

Another favourable dynamic that emerged this week was Standard & Poor’s announcement that it has put Australia’s economic risk score on positive watch for an upgrade over the next 24 months as housing imbalances unwind.

In May 2017 S&P downgraded Australia’s economic risk score from 3 to 4 (lower is better) because of concerns property prices and housing credit growth were increasing too quickly relative to incomes. S&P also questioned whether the Australian Prudential Regulation Authority’s (APRA) efforts to cool the housing boom via tighter lending controls would work.

While Australia’s economic growth remains very brisk—real GDP expanded at an above-trend 3.1 per cent over the year to March—national house prices have experienced a gradual 2.2 per cent correction since October 2017 as a result of APRA’s "macro-prudential" constraints.

This means Australia’s house price-to-income ratio is falling rapidly back to more normal levels at a time when the economy and the labour market are thriving. Indeed, were it not for a healthy rise in Australia’s labour force participation rate to record highs, our jobless rate would have fallen to 4 per cent (it is currently 5.4 per cent).

S&P’s Sharad Jain explained this week that if the rating agency restores Australia’s economic risk score back to 3, it is likely CBA and Westpac’s risk-adjusted capital (RAC) ratios will rise above the 10 per cent level that would normally earn them an upgrade to their Stand-Alone Credit Profiles (SACPs). While this improvement in their SACP would not impact the ratings of CBA and Westpac’s senior bonds, it would, Jain highlighted, boost the ratings of their hybrids from BB+ to BBB- and their subordinated bonds from BBB to BBB+.

This is significant because it would shift the hybrids back into “investment-grade” territory, which is anything rated BBB- or better, that ordinarily amplifies institutional demand. When S&P downgraded Australia’s economic risk score last year, there was a solid month of institutional selling of hybrids as they slipped into the sub-investment grade bucket.

While S&P says this could occur at any time over the next 2 years, the timing may correlate with the restoration of Australia’s sovereign rating back to a “stable” footing—it is currently on “negative” outlook—which will coincide with the budget moving back into surplus.

Our contrarian forecast on this front is that we get a surplus in the next financial year, and possibly before the end of 2018 on a rolling 12 month basis. (The budget has been in surplus for the last 7 months.)

In its July 2017 paper on optimal capital ratios, APRA advised the major banks that “averaging a RAC ratio above 10 per cent over the cycle would improve the likelihood of being perceived by financial market participants as having unquestionably strong capital ratios”. It further concluded that S&P’s RAC ratio was “a useful benchmark against which APRA can calibrate its own requirements”." Read more here.

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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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