Fixed Income

The media sometimes uses the terms “smart money” and “dumb money” to describe institutional and retail investors respectively. The premise is that institutions have full time employees that specialise in various sectors who are well placed to identify mispricing. Retail investors don’t have those resources and are therefore reliant upon shallower (if any) research in making investment calls.

I’ve often used the comparison between non-conforming residential mortgage backed securities (RMBS) and bank hybrids as an example of poor relative value. With the average margin on listed major bank hybrids ending the week at bank bills + 2.25%, the average is now sitting between the spreads on junior AAA and AA RMBS despite preference shares having an equivalent rating of somewhere in the BB or B rating area. (Click here for a primer on credit ratings.) The last RMBS deal issued with these two tranches was RedZed 2019-1, with the pricing at +1.95% (junior AAA) and +2.35% (AA).

I’ll take the comparison a step further and use the three securities from each major bank that have the smallest spread. (Each major bank has five securities outstanding, making twenty in total.) The average spread of these twelve securities is +2.01% and the average time to the first call date is 2.6 years. For the RedZed deal the weighted average life was 2.1 years for the junior AAA and 3.7 years for the AA.

The summary of this exercise is that the dumb money (retail) is buying and holding sub-investment grade securities that are arguably more equity than debt, whilst the smart money is buying AAA rated debt securities. Despite the massive difference in risk (arguably 26-95 times greater for BB/B preference shares versus AAA/AA RMBS) both groups are getting basically the same return.



Comments

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Mike Hickman

Nice analysis. How would you factor in the franking credit which for many investors enhances the yield ? Would this additional return to this investment class (say SMSF pensioner accounts ) justify the additional risk ? Mike Asset Selection Advisors

John Clark

So who gives RedZed AAA? While the bank Hybrids may not be AAA, reputational risk, and risk of future funding opportunities. would make them pretty safe. There are a number of other Hybrids on the market with second level borrowers where this would not be the case (AXSESSTODAY for instance)

Aaron Ross-Connolly

Hi Jonathan - there is something here that I don't understand. The Moody's Baa spread is currently 2.22% and that is over 10 years. So why is a RMBS with a AA rating and 2.7 years duration providing 2.35%. Something does not add up here. What am I not understanding? Greatly appreciated if you are able to put me on the right path.

Martyn Rose

My understanding is that retail clients cannot access RMBS issues like Redzed. So isn't it a bit harsh to say that Retail investors are dumb for Investing in Hybrids when the option you offer up is one they cant access???

Henry Kaye

Correct - this is overdue analysis Can one financial planner in the country who sells these things quantify the compensation in bps they should be receiving for the bail-in risk?

Jonathan Rochford

Thanks for all the questions and comments. The spreads I've shown include the franking credits, if you can't use franking credits the spreads are much less. Fitch and Moody's both gave the AAA rating to RedZed's two most senior tranches. The reputational issue didn't stop NAB, Suncorp, Macquarie and Bendigo from leaving their income notes outstanding long after their call dates passed. It also didn't stop a fair swag of European and American banks from going bankrupt during and since the financial crisis resulting in large losses for their hybrid holders. RMBS margins are typically much wider than comparable corporate credit spreads. That's largely a complexity premium with some additional premium for illiquidity. Fair point re retail investors not being able to access RMBS directly, although I did write a few months ago on alternatives. See "Bank Hybrids are a Screaming Sell". There are several institutional fund managers that own hybrids, as well as many family offices and they have no excuse for continuing to own them.