Where hybrids sit in a portfolio (and hunting housing bears)...

In the AFR today I explain why ever since I have pulled out my empirical “shotty”, an intellectual 12-gauge, the housing bears have started running for the hills. In fact, I am getting increasingly excited about the prospect of making myself a bear BBQ. Click on that link to read my column or AFR subs can click here. 

Our base case is that Aussie house prices will flatline over the next few months, with the risk of a modest softening of prices up to 5 per cent. Thereafter we forecast that the 2019-20 boom will reassert itself, with prices climbing by another 10 per cent to 20 per cent on the back of the 75-150 basis point reduction in mortgage rates over the last year. This has massively boosted purchasing power, pushing down interest repayments as a share of disposable incomes to their lowest levels in decades. 

The data is supporting our contrarian case. In contrast to the bears’ gloomy expectations, national house prices appreciated in February, March and April. And in May they have been flatlining. In this AFR column, I also discuss where hybrids sit in a portfolio. Excerpt enclosed:

The revival of the search for yield dynamic was evident during the week with exceptionally strong interest in Macquarie Bank’s new Capital Notes 2 hybrid security (ASX: MBLPB). Macquarie ended up issuing only $500 million juxtaposed against investor demand of close to $2 billion.

MLPB priced on a chunky credit spread of 4.7 per cent above the quarterly bank bill swap rate, which provided for a grossed-up annual yield of 4.8 per cent. Importantly, this spread was materially above the circa 4.2 per cent margin offered on major bank hybrids with similar expected maturities of around 5.5 years.

While there is a one notch difference in Standard & Poor’s credit rating on these securities—S&P rates the major banks’ hybrids at the “investment-grade” BBB- level while applying a one notch lower “high yield” BB+ rating to Macquarie’s securities—they trade similarly on the ASX. (Technically, S&P only rates the unlisted version of these assets.)

This is likely because Macquarie’s yields have a lower franking rate and a correspondingly higher cash component as a result of its unfranked offshore earnings, which can be appealing for some. In debt markets Macquarie is also increasingly considered a “fifth pillar” with its A+ rated senior bonds just one notch behind the majors’ AA- senior securities. Here there is a case to be made that Macquarie has a superior risk management track-record to the big four.

Since the global financial crisis (GFC), major bank hybrids have traded on a credit spread of about 3 per cent over the bank bill swap rate with Macquarie’s securities recently pricing in line with the majors’ curve. If these spreads continue to mean-revert back to their post-GFC averages, which is our base-case, MBLPB holders will capture substantial capital gains.

To date major bank spreads have compressed from their historic highs in March 2020 around 8.4 per cent above bank bills to 4.2 per cent over in May. (We net bought $294 million of bank hybrids between late February and mid April as investors were rushing for the exits.)

Aussie banks are deferring or slashing their dividends to build their equity capital buffers, which directly protects bond and hybrid holders from default risk (or equity conversion). They have also always paid the income distributions on their hybrids and just as importantly continue to repay the principal sum when expected.

Since February Macquarie has repaid two hybrids worth $829 million (MBLHB and MBLPA); NAB has a repaid a $1.34 billion security (NABPC); Bank of Queensland repays a $150 million hybrid this month; and Suncorp will repay its $194 million SUNPE instrument in June.

When we model the required credit spread on MBLPB assuming a 1-in-10 probability it goes into default and a 100 per cent loss in this event, we arrive at a minimum spread of about 2.2 per cent above bank bills before accounting for other variables like liquidity. The proposed 4.7 per cent spread was therefore attractive (we subscribed).

One question I am regularly asked is where hybrids should sit in a portfolio. As noted above, S&P rates major bank hybrids in the “investment-grade” BBB- band while applying a “high-yield” BB+ rating to Macquarie’s securities. These ratings convey S&P’s assessment regarding the default risk and recovery rates on these instruments.

The current 4.2 per cent spread above bank bills available on major bank hybrids is miles above the spread one normally earns on BBB rated investments. According to the Federal Reserve, the current average spread on BBB rated corporate issues in the US is only 2.9 per cent. Here in Australia Woolworths just priced a remarkably cheap (for the issuer) BBB bond at a spread of merely 1.45 per cent above bank bills. That’s less than the 1.7 per cent rate you can get on a government-guaranteed 12 month term deposit that is de facto rated AAA! (We had fair value way above the miserly Woolworths' spread and therefore quickly rejected it.)

The purpose of these credit ratings is to abstract away from the complexities inherent in the issuer’s creditworthiness and the manifold terms and conditions of the securities in question. Would you rather own a BB- rated senior unsecured bond issued by the oil and gas company Petrobas or a BB+ rated hybrid issued by Macquarie Bank, which has government guaranteed deposits and access to emergency funding via the RBA? I know what I would rather...

Aussie bank hybrids have a role to play in the “high-yield” bucket in fixed-income portfolios where you tend to find a fair bit of equity “beta”. With this in mind, the Bloomberg Barclays Global High Yield Index has a very similar risk and return profile to the ASX hybrid market over time. In the last five years, the global high yield index has returned 2.7 per cent annually with 5.6 per cent annual volatility (returns were hammered in the huge March shock). ASX hybrids have done better with a 5.3 per cent return with similar 5.1 per cent volatility. In March, the ASX hybrids index fell 6 per cent, global high yield slumped 13.5 per cent, ASX equities lost 21 per cent and major bank stocks dropped by about 25 per cent to 35 per cent.

Whereas global high yield bonds are currently suffering from an enormous spike in defaults and downgrades, which will continue, I do not expect Aussie bank hybrids to go into arrears.