Value in Australian Hybrids: Are We There Yet?

Jonathan Rochford

Narrow Road Capital

Credit is about avoiding losers

One of the mistakes that equity investors often make when thinking about credit investing is forgetting that credit is all about avoiding losers. It’s nice for a borrower to have solid growth prospects, but it’s not essential. What it must have is a very low probability of deteriorating. Picking seven out of ten winners makes an equity manager successful, but is a huge failure for a credit manager.

For those who have seen the movie Moneyball, you might remember the scene where Brad Pitt is teaching the scouts how the new selection process is going to work. He throws out of a bunch of names the scouts don’t like, but says they are going to be joining the team regardless. The scouts keep asking why he likes the players and the answer keeps coming back “because he gets on base”. Credit is the same – investors should like credits because they will get their money back under all reasonable scenarios. Simply substitute the baseball statistics of on base percentage and slugging percentage for the key credit statistics of probability of default and loss given default.

 

Don’t ignore the details

Whilst many deals can be grouped together as the same security type there can be subtle but significant differences. For instance, ANZPC has a maximum exchange percentage of 50% if a regulatory trigger occurs whereas other similar securities have this set at 20%. This means that if APRA orders that ANZ preference shares be converted to ordinary equity, ANZPC holders will get fewer ordinary shares than other ANZ preference shareholders. Conversely, ANZPC has the lowest VWAP of the ANZ preference shares. This means that if ANZ’s share price halved from current levels all other ANZ preference shares would be blocked from mandatory conversion and would miss their first call dates. ANZPC would still pass its mandatory conversion test giving investors a realisation event, when others securities are stuck without one for an indeterminate period.

 

Bank capital levels have finally improved

Up until last year many investors mistakenly thought that Australian banks were much better capitalised since the financial crisis. Whilst the tier one equity ratios had increased, this was primarily as the equity required to support residential mortgages had decreased. When comparing the amount of tangible equity with the asset base there was very little improvement. This finally changed in 2015, eight years after the credit crisis began. 

For Australian major banks, APRA changed two key components on equity levels last year. Firstly, APRA flagged that banks will need to hold higher amounts of capital against their residential property loans. Westpac will be most impacted by this change and recently noted that its tier one capital ratio would drop from 10.2% to 9.1% as a result of this change, leaving other factors unchanged. Secondly, APRA agreed with the Financial System Inquiry that banks should be in the top 25% globally by capital ratios. This saw a wave of equity raisings last year, with the likelihood that another round may be needed this year. Put together, by 2017 preference shareholders will have a significantly larger slice of equity below them, decreasing both the probability of default and the loss given default.

 

But the risk of home loans is higher

The 60 Minutes story about Australian residential property in February was a little over the top, but still a helpful reminder that residential property in Australia is very, very expensive. Both major political parties are talking about restricting negative gearing and there’s even minor mentions of broad based land tax and removing some of the discount on capital gains tax. None of this is good news for residential property investors or the banks that have made highly leveraged, often interest only loans, using foolishly low assumptions of living expenses and interest rates.

The fact that banks were using the Henderson Poverty Index as a cost of living indicator for middle and high income households was completely nuts. Anecdotally it appears that this practice still continues. This means that marginal borrowers have received loans higher than they can comfortably support. Stress tests typically assume that lenders mortgage insurance will cover most or all of the losses if unemployment increases and house prices fall. However, if we do have a property bubble then the insurance providers are unlikely to be able to pay all claims they receive and losses will also spill over to loans that don’t have insurance cover.

 

Listed note holders are usually passengers

Preference shares and long dated debt securities give rights to the Board of the issuing company about whether their payments will be made on time or at all, and when their principal will be repaid. The history of listed notes is that some Boards prioritise ordinary shareholders over preference shareholders. Paperlinx and Elders preference shareholders haven’t been paid for years, and there’s eight other securities that have gone past their call dates. Standard debt securities have the threat of insolvency as the stick to see that their interest and principal is paid on time, whereas most listed notes leave their holders as passengers subject to the discretion of the Board.

Noteholders of Crown have learnt this lesson in the last six months, as James Packer has worked away on a potential take-private transaction. There has been limited disclosure from the Board about whether a deal could happen and what action they might take in regards to the long dated securities if a deal was done. The notes have accordingly traded down, as noteholders have to consider the possibility that they might become a very cheap form of mezzanine debt in a company that could become more highly leveraged that it is now.

 

Lower margin doesn’t mean lower risk

Long term holders of the old style income securities, notably BENHB, MBLHB, NABHA and SBKHB, know the dangers of buying into a security with a low margin. Even if the securities no longer qualify for tier one or tier two capital calculations, they can end up being a cheap form of perpetual debt. The best outcome could be that that the issuer offers to buy back the securities at premium to the current price but less than the face value or allows for conversion into a new security with better terms. Holders of PCAPA have avoided the fate of the old style income securities even though their margin was low. Holders of WCTPA are expecting the same outcome, but there is a small possibility that it isn’t called or that holders need to switch into a new security to get their principal back. 

Holders of CBAPD find themselves with an interesting decision. Should they sell out at a loss and buy into the new CBAPE security or stick with what they have? Assuming a clean switch could be completed at a similar margin to call, CBAPE is clearly a superior security. It has a shorter period to the first mandatory conversion date and is likely to have a lower VWAP price. The higher margin received (as opposed to margin to call) means that CBAPE holders will be in a much better position if the CBA share price falls and mandatory conversion conditions can’t be satisfied.

 

Summing it up

With the current average margin of bank bills + 4.98% close to double the cycle lows of 2014 value is certainly better than it was. Some listed notes I’ve ignored in the past are now at or close to levels where they could be considered as acceptable additions to a portfolio. However, I continue to only recommend a handful to clients as the relative value hasn’t improved as much as it might first appear. The pricing of a Westpac subordinated debt issue at bank bills + 3.10% in February and the drift wider in listed equivalents shows that the closest alternatives to bank preference shares have also become cheaper.

For institutional and family office investors, Australian private debt remains more attractive than listed notes. Here buyers are paid very well for illiquidity, with limited credit risk taken. I’m seeing a growing pipeline of transactions where a first ranking position is offering 7-12%. These very much fit the Moneyball analogy, transactions where I believe clients should invest because I’m confident they will get their money back on time and in full. 

Written by Jonathan Rochford for Narrow Road Capital on February 29, 2016. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com

 

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.


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Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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