Navigating the hybrid maze

Transcription

1 Navigating the hybrid maze John Likos, CFA Head of Credit Research, Morningstar Australia 2014 Morningstar. All Rights Reserved.

2 Important Information Any Morningstar ratings/recommendations contained in this presentation are based on the full research report available from Morningstar or your adviser. Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. No part of this document may be reproduced or distributed in any form without the prior written consent of Morningstar. Any general advice or class service have been prepared by Morningstar Australasia Pty Ltd (ABN: , AFSL: ) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN ("ASXO"). 2

3 Agenda Hybrid security basics. Key risks of hybrid securities. Hybrid security issuance. Hybrid securities in the asset allocation process. Morningstar s hybrid methodology. Summary. 3

4 What is a Hybrid Security? Hybrids combine both debt and equity characteristics. Equity like characteristics: Long maturity (sometimes perpetual). Issuer s ability to suspend distributions or delay redeeming the security. Deep subordination on the capital structure. Loss absorption features. Debt like characteristics: Represent an obligation to the issuer. Pay a regular and defined rate of return (fixed or floating). No voting rights. Fixed maturity or conversion dates. 4

5 Capital Structure Priority of Payment in Winding Up Senior Secured Debt Lowest Risk Application of Losses Senior Unsecured Debt Subordinated Debt Hybrids Equity Highest Risk 5

6 Advantages & Disadvantages of Hybrid Securities Advantages: Provide higher yields than traditional bonds. ASX listing provides improved liquidity over traditional OTC fixed income. Generally ranks above equity in the capital structure. Potential tax benefits in the form of franking. Disadvantages: Complex products, often difficult to understand and price the risks. In times of financial market distress, can display high price volatility. Ranks below traditional debt on the capital structure. Distributions can be discretionary and non-cumulative. 6

7 Financial Crisis Volatility is High During Periods of Financial Market Stress $190 $170 $150 $130 Common Equity (ASX Code: CBA) PERLS V (ASX Code: CBAPA) PERLS IV (ASX Code: CBAPB) PERLS III (ASX Code: PCAPA) PERLS II (ASX Code: PCBPA) $110 $90 $70 $50 7

8 Hybrid Risks Credit risk risk of loss arising from the issuer defaulting on its payments. Liquidity risk risk that investors won t be able to exit their positions at their desired price and time. Complexity risk risk of mispricing the security on the basis of misunderstanding the structure. Interest rate risk in the case of floating rate securities, the risk that interest rates decrease and distributions follow. Subordination risk risk of no recovery in the event of a winding up. Extension risk risk of the hybrid staying on issue for a longer period than expected. Capital trigger risk risk of conversion to equity if the issuer s common equity Tier 1 capital ratio drops below 5.125%. Non-viability risk option to APRA to request conversion or write off hybrid if they believe the issuer could become non-viable without an injection of capital. 8

9 Hybrid Risks 9

10 Drivers of Issuance Key drivers of issuance: Banks have looked to raise capital to meet the stricter Basel III regulatory requirements. Replacing maturing securities issued under previous regulatory frameworks. Credit Rating Arbitrage for rating / capital sensitive corporates (AGK, ORG): Help corporates fund large capital expenditure projects and acquisitions without having a major impact on their credit rating. Low interest rate environment has driven consumer demand for these relatively higher yielding securities. Another means of diversifying funding for issuers. 10

11 Hybrid Issuance Insurance Financial Corporate AUD million 4,500 4,000 3,500 Source: Morningstar 3,000 2,500 2,000 1,500 1, Qtr1 Qtr2 Qtr3 Qtr4 Qtr1 Qtr2 Qtr3 Qtr4 Qtr1 Qtr2 Qtr3 Qtr4 Qtr1 Qtr

12 Hybrid Securities in the Asset Allocation Framework Hybrid securities are not a direct replacement for traditional fixed income securities or term deposits. Treasury bonds and vanilla corporate bonds are traditional fixed income securities and therefore easily fit into this traditional asset class bucket. Hybrids are designed with both debt and equity like features and therefore there is some confusion about whether they should be treated as fixed income or equity. We would argue that if you are using a risk based asset allocation framework all securities with equity like features (including discretionary interest payments) should be classified as equity for the duration of its life. 12

13 Long Term Return Hybrid Securities in the Asset Allocation Framework 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% Cash Long-Term Capital Markets Assumptions Bonds Hybrid Securities Equities 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Standard Deviation 13

14 How Does Morningstar Analyse Hybrid Securities? Distinguish the hybrid security type. All carry distinct terms and conditions, which make it difficult to standardise a credit assessment. Credit analysts work with the equity analysts, utilising their expert knowledge and forward looking financial models of the issuer. Place the security into one of the investment risk categories of low, medium, or high. Estimate a fair margin that we believe compensates the investor for the relevant risks. Compare this margin to similar securities to derive a relative value view. Combine the fundamental analysis with the relative value analysis to make a recommendation. The most important step in this process is Morningstar's fundamental analysis of the issuer, which revolves around our Economic Moat methodology. 14

15 Morningstar Economic Moat Rating Sustainable competitive advantages that allow a company to generate positive economic profits for the benefit of its owners for an extended period of time. Wide Narrow None 15

16 Economic Moats in the Context of Hybrid Securities Companies with a narrow moat are likely to achieve normalised excess returns beyond 10 years while wide moat issuers are likely to sustain excess returns beyond 20 years. Economic moats bolster credit quality. Moats are especially important for long-dated securities (i.e. Tier 1 securities): Relevance of current conditions (e.g. leverage, liquidity) decreases for longer-dated securities. Relevance of structural traits (moat or lack thereof) increases for longer-dated securities. As term to maturity increases, we demand more spread pickup on a no moat issuer than a wide moat issuer. Cash flows are less certain therefore we demand a higher return. 16

17 Morningstar Economic Moat Rating - Sources There are five sources of economic moats. Intangible Assets Switching Costs Network Effect Cost Advantage Efficient Scale Wide Narrow None 17

18 Case Study: CBA PERLS VII (ASX Code: CBAPD) Security type: capital note. Economic moat: wide. Security investment risk: medium. Estimate fair margin: 3.30% (compared to the listing margin of 2.80%). Comparable security: WBCPE, trading around 2.80% at the time. CBA shares yielding ~7.5%. Recommendation: DO NOT SUBSCRIBE. Although CBA is a preferred issuer, we believed the trading margin wasn t adequately compensating investors for the requisite risks. Implications: Price was down ~3% on listing. 18

19 Summary Steady stream of issuance in the coming years, particularly from financial institutions. Hybrids are not a substitute for traditional fixed income or term deposits. New style bank hybrids have more equity like features, should be priced accordingly. We believe our moat focused approach will continue to identify value in the hybrid universe. Good quality hybrid securities have a place in a diversified portfolio. Don t buy what you don t understand. 19

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