What Bill Shorten’s New Tax Rules Mean for Equities, Hybrids and Property

Christopher Joye

Coolabah Capital

Labor leader Bill Shorten is certainly bold when it comes to assaulting the financial heartlands of Australian housing, equities and super.

Shorten is proposing to halve the current 50 per cent capital gains tax discount on investment properties to 25 per cent on all assets purchased after 1 July 2017. And he will abolish negative gearing on all assets bought after 1 July 2017 other than newly constructed dwellings.

According to the ABS, about 21 per cent of households own a second home that would count as an investment property. While Shorten’s rules will not technically apply to anyone who bought prior to mid 2017, they will directly impact the value of these assets insofar as any new purchaser will both have to pay much more capital gains tax and be denied the opportunity to negatively gear.

And since investment properties (including holiday homes) make-up 35 per cent of all Australian dwellings, Shorten’s new taxes on the largest source of household wealth will unambiguously reduce the value of owner-occupied and investment properties relative to the alternative of no tax change.

The beneficiaries are future home buyers, who will get more affordable dwellings, although the assets they inherit from their parents will be worth less, all else being equal. And voters may discount the value they attach to the extra government spending enabled by this revenue-raising if past public works programs, like the NBN or pink batts, are any guide.

This week Shorten revealed that he also wants to deny retirees the ability to capture any cash rebates from the tax office when the franking credits they receive on equities exceed the amount of tax they pay. This is particularly punitive on lower-income retirees that have less than $1.6 million in their pension accounts and who pay not tax at all.

Many of these savers have loaded up on defensive, high yielding stocks like Telstra, Woolies, CBA, ANZ, NAB and Westpac that pay dividends with franking credits equal to the value of the tax the company has paid. The retiree then earns cash rebates from the tax office equal to the value of these credits, which boosts the annual dividend return they get from 5.6 per cent to 8.0 per cent in the case of CBA shares (or from 8.0 per cent to 11.4 per cent in respect of Telstra).

Shorten’s plan to eliminate these cash rebates will slash retirees' franked dividend income by 30 per cent if they have less than $1.6 million in their pension. Unfortunately, these are folks who rationally have built-up franked equity portfolios over the last 17 years on the basis of cash rebate rules that were supported by both Labor and the Liberals. And politicians wonder why nobody trusts them!

Shorten’s proposals seem politically hazardous and will surely compel affected property owners and retirees to swing their support behind Turnbull at the next election on purely financial grounds.

I've been asked how these changes could impact the listed hybrid market, which are dominated by bank issued Additional Tier 1 (AT1) capital securities that pay fully-franked income distributions.

The latest hybrid issued by Westpac (ASX: WBCPH) listed at a 1.4 per cent capital loss on Wednesday, as we predicted it would. But this had nothing to do with Shorten’s plan. Westpac chose to pay an unusually skinny margin of just 3.2 per cent above the bank bill swap rate on WBCPH, which was a large 0.23 per cent annually less than the fair value margin we had estimated (ie, 3.43 per cent).

It just so happens that WBCPH’s closing price of $98.60 translates into exactly a 3.43 per cent spread above bank bills. The problem for WBCPH owners is that this was the fair value spread back in February and the hybrid market has since been weighed down heavily by more than $3 billion of new supply from Westpac and CBA. (We did not invest in either WBCPH or CBAPG.) Our analysis implies that fair value for WBCPH is now a margin north of 3.8 per cent above bank bills or a price below $96.50, which hints at more downside risk for this specific security even though the overall hybrid sector looks quite cheap.

Shorten’s plan to eliminate cash rebates will have no impact on any investor that pays tax than can be offset with franking credits, which accounts for 92 per cent of taxpayers including institutions, pooled super funds, self managed super savers in pre-retirement accumulation phase, private individuals, high net worths, and the charities and not-for-profits exempted from the rule change.

The cohort that is affected will be low-income retirees with less than $1.6 million in tax-free super. As actuaries Michael Rice of Rice Warner and David Knox of Mercer have explained to media, wealthier retirees with more than $1.6 million in super who pay tax on their non-pension investments can simply restructure their investments. They would place their non-franked cash deposits, bonds and property in the tax-free pension account and keep their equities and hybrids in super where they continue to pay tax and can benefit from franking credits.

Since hybrids are a crucial source of equity capital for the banks that are both designed and required by the regulator, APRA may seek to follow past precedents and exempt (or "grandfather") all outstanding securities from the new rules until they are replaced over the next circa 7 years. This happened with the introduction of the Basel 3 banking rules and when the tax office prevented the banks from franking a hybrid and claiming a tax deduction on its income payments.

It is currently cheaper for Aussie banks to issue hybrids into the US dollar market, as ANZ, Macquarie and Westpac have done of late. Overseas institutional investors demand much lower yields on these securities than those captured by ASX participants. I would as a result expect to see the major banks and Macquarie undertake more US dollar issuance and unlisted over-the-counter deals for domestic institutional and high net worth investors that will probably accept smaller spreads.

This will further starve the ASX of hybrid and subordinated bond supply, which is becoming a big problem for retirees that rely on the steady income afforded by these securities. ANZ and Westpac both chose to refinance their ASX listed subordinated bonds (ANZHA and WBCHA) in the unlisted over-the-counter market and it is likely Suncorp (SUNPD), AMP (AMPHA) and Westpac (WBCHB) will do the same.

That means that $5.2 billion of subordinated bonds have disappeared, or will vanish, from the ASX. We could see a similar same trend with hybrids given local institutional demand for these low volatility securities continues to grow strongly with reports of chunky bids of up to $100 million from super funds in the latest Westpac and CBA deals.

The bottom line is that mums and dads will be fighting to invest in a smaller pool of listed debt and hybrid securities unless they access the wholesale over-the-counter market via a fund or ETF.

Pensioners with less than $1.6 million who pay no tax may be forced to just accept lower unfranked returns. The unfranked 5.5 per cent to 6.5 per cent dividend yield on major bank stocks still smashes the 1.8 per cent yield they can get on US equities. Likewise the circa 4.0 per cent (or higher) unfranked annual yields on major bank hybrids are still way above 2.3 per cent to 2.5 per cent term deposit rates or the 3.4 per cent you earn on major bank subordinated bonds.

The only way a retiree could get a better unfranked yield is by going into an unrated or sub-investment grade junk bond fund. Bentham and Metrics offer yields of 4 per cent to 5 per cent, but this comes with arguably much higher default risks coupled with inferior liquidity.

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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