Income Series 2019
Christopher Joye

Australians tend to have a lot of cash, property, and equities. There is not much in between. Hybrids, however, generally pay a healthy regular income on a quarterly basis at a substantial spread above the RBA cash rate. 

Currently, five-year major bank hybrids are paying about 5% pa, including franking. This translates into a credit spread of about 3.36% pa above the quarterly bank bill swap rate (BBSW) where the latter is roughly 1.63% pa.

This credit spread on major bank hybrids compares favourably to their senior bonds, which currently pay about 0.85% above BBSW, and their Tier 2 subordinated bonds, which pay about 2.0% above BBSW.

Historically, a market-cap weighted index of ASX hybrids have had around one quarter to one third the return volatility of the ASX equities market and incurred less than half the losses suffered by Australian bank shareholders during the 2008 to 2009 crisis.

5 rules to follow

Coolabah applies five portfolio construction rules that tend to focus on a number of core questions. 

  • First, is the issuer a business that has any inherent risk of blowing up or being downgraded in credit rating terms? 
  • Second, is the security being issued liquid and tradeable?
  • Third, do our valuation models signal that the security is mispriced? 
  • Fourth, what is the probability of mean-reversion or normalisation in the security’s spread? 
  • And finally, what are the market technical, and general demand and supply dynamics, surrounding the security? 

Where to find the best opportunities

Right now, hybrid securities (particularly, major and regional bank Additional Tier 1 capital hybrids) are some of the cheapest assets we own in our portfolios. Five-year major bank hybrids currently yield 3.36% over the Bank Bill Swap Rate (BBSW), or about 5% inclusive of franking credits.

Compared to a pre-GFC 5 year major bank hybrid spread of 1.25% above BBSW and a post-GFC tight spread of 2.30%, these securities look attractive, especially when you consider that Australia’s major banks have halved their risk-weighted leverage since 2007, massively increased the amount of equity they hold (which protects hybrid holders against default risk), and have been selling their non-core, more risky business units (wealth, insurance, etc.)

The sector is currently being re-rated in the wake of the Coalition’s victory in the May 2019 Federal Election. When the ALP announced its policy to remove cash rebates for franking credits in March 2018, hybrid spreads over BBSW blew out by 1.00% over the next two months as potentially affected investors sold their holdings.

While others in the market panicked and sold hybrids or switched into risky debt LIC/LIT vehicles which were opportunistically sold to capitalise on the possibility of an ALP government, Coolabah believed that: 

  1. The impact of the policy would be ultimately limited given the still attractive cash yield hybrids provided and the relatively small number of people the policy would affect (ie. all securities would be held by folks that can claim franking credits), and more importantly; 
  2. That either the Coalition would record an unlikely victory, or the franking policy would not be able to get through a hostile Senate.

Ultimately, accumulating hybrids at elevated yields was the correct decision, and the sector should be very well supported in the coming months as those advised to sell or switch their holdings re-enter.

This market is also highly supply-demand driven – when issuers offer new hybrids, investors sell other hybrids, driving down prices. When the reverse is true, and no large new hybrids are expected to be issued, the market is awash with cash and is faced with constant buying pressure. Right now, the supply-demand outlook is attractive, with few new issues expected and a number of hybrids being redeemed for cash by issuers.

Finally, we see a strong probability that the credit rating for the major banks’ hybrids will be upgraded by Standard and Poor’s from BB+ to BBB-, putting them back in the all-important ‘investment grade’ category if S&P upgrades Australia’s economic risk score, which it has said it is trending towards doing. This would allow more fund managers, super funds and investors to buy these securities in their portfolios, which in turn would add another source of demand for the sector.

What we're avoiding

The ASX-listed hybrids universe contains some highly complex, idiosyncratic and illiquid securities that Coolabah generally avoids. While in some cases corporate capital management policies can see these securities gain as they are repaid early, when the underlying businesses are highly risky these securities can present huge tail risks for holders.

With one of our prime aims being to preserve clients’ capital, we deliberately choose not to take the risk of such a catastrophic loss and focus on more liquid securities that have extremely low probabilities of default.

Some pitfalls to be aware of

The key challenge with hybrids, or for that manner any security up or down the capital structure, is being able to appropriately value them. This, in turn, requires one to be able to model the business’ risks, predict the probability of default and recovery rate, and then estimate the required liquidity risk premium vis-à-vis the global universe of alternative assets. 

Generating income and adding value

As an active fund manager, we aim to add value by buying mispriced securities paying too much interest and selling them when the interest rate normalises back to our proprietary estimate of fair value. That is to say, we aim to deliver alpha, not credit beta, illiquidity beta or interest rate duration beta.

We run numerous quantitative valuation models that revalue every bond in our investable universe intraday, working out the fair value spread (or interest rate) the bond should offer to compensate the holder for its risks and characteristics – its issuer, tenor, credit ratings, liquidity and so on.

We identify bonds that pay excess yield for their risks and if they pass through our credit due diligence filters, add them to our portfolios, aiming to sell at a lower yield (higher price) when the excess yield mispricing mean-reverts or normalises.

We also add value through deep relationships with a network of brokers in the ASX hybrids and OTC markets. We are positioned to capitalise on any strong selling and buying flows in the hybrid market, either as a means to obtain the best possible execution, or to identify undervalued or overvalued securities.

Investing across the capital structure

Coolabah Capital Investments manages a range of solutions that can invest up and down the corporate capital structure from AAA-rated covered bonds to BB-rated hybrids. As one of Australia’s largest fixed income boutiques across multiple active credit strategies, we have a track record of delivering consistent alpha for our predominantly institutional clientele. Across our last 4,500 bond sales, its pre-fees “win ratio”, defined as the proportion of the time we make money after buying and selling a bond, is north of 98%.

Our most hybrids focussed solution is the Betashares Active Australian Hybrids Fund (ASX:HBRD), which is the first actively managed fixed income ETF in Australia and the only Australian ETF that concentrates on ASX listed hybrids with the protection of being able to go 100% into cash if hybrids become very expensive.

HBRD has an absolute return target of the RBA cash rate plus 2.5% pa, and it has historically beaten that quite comfortably, delivering 5.1% pa net of all fees since inception in November 2017. (Please note our disclaimer below.) This has been encouraging given how difficult 2018 and 2019 were for the ASX hybrid market with the threat of regulatory change that has been removed via the comprehensive Coalition election victory.

HBRD is currently diversified across 43 bonds and hybrids with an 88% portfolio weight to the ASX hybrid market and a gross running yield of 5.10% pa.

The hybrids that HBRD invests in are all tradeable hybrids issued by well-known Australian banks and insurers that offer attractive total yields relative to the RBA cash rate.

These hybrids are quite different to illiquid corporate hybrids, unlisted direct loans, and/or unlisted high yield bonds issued by much smaller businesses with higher inherent credit risk than the large Australian banks and insurers.

HBRD is, in fact, an active capital structure solution because we can invest up and down the corporate capital structure in cash, senior bonds, subordinated bonds and preferred equity hybrids depending on where we see the biggest relative value opportunities. That is, wherever we can find the best interest rates after adjusting for both the security and the issuer’s risks.

Hybrids can be difficult for the average investor to value, price and successfully trade. HBRD provides access to a professionally managed portfolio of hybrids and bonds where the hard work of researching, valuing and pricing these securities is done by a dedicated 12-person team.

HBRD currently has a gross running yield of 5.1%. Over the long term HBRD targets:

  • Absolute post-fee returns in excess of the RBA’s cash rate target + 2.5% pa
  • A franked running yield similar to that of the ASX hybrids market
  • Outperforming the ASX hybrid market with a focus on the safer banks and insurers
  • Return volatility of less than one-third of the equity market’s risk

Want access to a steady stream of income?

As one of Livewire’s valued contributors, Coolabah has committed to educating investors about income investing through this installment in the Livewire Income Series. To find out more about the income options that Coolabah provide, please click the 'contact' button below.

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Disclaimer: This information is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Past performance is not an indicator of nor assures any future returns or risks. Smarter Money Investments Pty Limited (ACN 153 555 867) is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd, which holds Australian Financial Services Licence No. 482238 and authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited that holds Australian Financial Services Licence No. 255016.



Comments

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Mr T

chris - you're awesome and your funds do well (thanks!). i have confidence in you. it would be nice to think HBRD and similar ETFs could be used as a cash alternative. But i am unclear about the liquidity risk of doing this via an ETF. So, Q1: For punters that might want to invest in HBRD - if the market had a major blow up, do you think there is any meaningful risk that the ETF Authorised Participant(s) step away from HBRD, and investors are unable to redeem their units or unable to redeem at a price close to Net Asset Value? Q2: In a market crash situation, do you think the Market Maker(s) for HBRD could go bust or otherwise be unable to make a market, and what would happen for HBRD investors if this happens? [Guessing investors just have their investments 'temporarily' locked up as held by trustee rather than the MM in this instance?] As background, my understanding is that there are documented instances where APs HAVE refused to trade ETF units in the US in the past (..."APs are not obligated to create or redeem ETF shares, and an AP engages in these transactions only when they are in the AP’s best interest given market conditions. This could have potentially negative effects on the ability to trade without accepting significant discounts to the estimated value of the underlying assets if, for example, one or more APs were to pull back from the market in turbulent conditions.”) Also, Lehman etc going bust in GFC is example of Market Maker going bust, so presumably it could happen again? ps (for anyone still reading!) - Retail investors can invest in Chris' retail funds via mtrade if they want to avoid ETF risk. It's clunkier, but possible if investors feel the ETF risk is unacceptable.