Liquidity and Technical Drivers of Hybrids

Bank hybrids have been issued in the Australian financial landscape for over 20 years in various forms. While drivers of performance have varied over this period, they are typically cyclical and have a recurring impact on security trading margins (albeit at different magnitudes). The focus of the article will be on what is technically known as an Additional Tier 1 capital security (hybrids), and our expectations for market drivers over the next twelve months. 1. Supply & Demand After a shaky start to 2016, demand for major bank issued hybrids has been strong both in the secondary and primary markets. This demand has been predominately driven by investors continuing their search for higher yielding investments against the backdrop of a low interest rate environment. Australian interest rates have been driven lower over 2016 as the Reserve Bank of Australia (RBA) has reduced the cash rate from 2.00% to 1.50% during their May and August meetings, with the prospect of a terminal cash rate of 1.25% or lower remaining a possibility. At the start of the year there were also some supply side concerns as ~$3.9 billion of major bank hybrids were due to be replaced. Fast forward to September and all three hybrids have been replaced successfully. All three replacement hybrids priced at the low end of their respective book-build ranges and were oversubscribed reflecting the strength in demand. The NAB has also been able to successfully issue a hybrid during 2016 despite not having a replacement scheduled until 2019. New hybrid issuance is expected to remain low over 2017-18 as there are only 3 major bank hybrids are due to be replaced as Figure 1 shows (although the prospect of a non-replacement issue remains a possibility). The main reason for the gap in the replacement profile can be traced back to the lack of issuance between December 2009 and September 2011 due to uncertainty surrounding the introduction of capital instrument eligibility criteria specified under Basel III regulations (a direct response to events causing the Global Financial Crisis (GFC)). It is not until 2021-22 that the replacement pipeline starts to get congested, culminating in the $3 billion PERLS VIII replacement due in December 2022. Potentially bank treasurers may decide to issue early to deal with this congestion or to upsize replacement issuance from 2019 onwards. Figure 1. Domestically issued Major Bank hybrid replacement schedule Source: BondAdviser 2. Valuations 2016 has also seen the return of institutional (or wholesale) investors to the hybrid market as evidenced by some large cornerstone investors appearing in the initial top 20 holder statements (released to the ASX on the first day of trading). The re-emergence of institutional investors via the primary market in 2016 has been one of the factors why trading margins began to compress from recent highs as smaller retail investors have received lower allocations and have sought supply via the secondary markets. A technical reason for widening margins of hybrid securities over 2015 was due to financial advisers re-classifying these instruments as equity rather than debt (as anything pooled as bank equity performed poorly until February 2016). This is an anomaly which is unique to Australia and has little to do with the associated security risk. Some institutional investors have clearly taken this anomaly as an opportunity to buy hybrid securities at levels not seen since the height of the GFC. Figure 2. Average major bank hybrid trading margins Source: BondAdviser as at the 15^th of September 2016 Hybrids have performed well since mid-February and are currently trading in the middle of the post-GFC range. We believe that the demand/supply dynamics discussed above remain supportive of trading margins at current levels. Hybrid securities are higher risk instruments than traditional debt and investors should expect to receive greater returns than securities issued higher up the capital structure (i.e. senior bonds) to compensate for the increased credit risk. One way to quantify this compensation is to calculate the multiple of the trading margin of hybrids over that of senior floating rate notes (FRN), whereby a higher multiple indicates a higher level of compensation. Figure 3 tracks how this multiple has moved since September 2012. As a rough rule of thumb a multiple above 4 is attractive and this further supports our thesis. Figure 4. Major Bank Hybrid/Senior FRN Bond Multiple Source: BondAdviser, as at the 15^th of September 2016 3. Diverging Monetary Policy In 2015 we witnessed trading margins widen across the bank capital structure primarily as a result of an increase in systemic risks (largely driven by macro geopolitical and policy risks associated with foreign nations). To offset this, technical measures such as the European Central Bank’s Bond Buying Program were set up to ensure yields/margins remained stable. During late 2015 and early 2016 China was also forced to use experimental policies to stabilize markets and the Bank of Japan followed suit on the 29^th of January 2016 by setting a negative interest rate for selected types of deposits. However, mitigating this level of stimulus is the desire of the US Federal Reserve Bank (The Fed) to embark on the second increase to US Federal Funds Rate and to wind back some of the quantitative easing program that was introduced during the GFC. This divergence in global monetary policy and the subsequent impact on interest rates is uncertain but if history is anything to go by, investors and uncertainty is a recipe for sell-off in risk-assets (including hybrids). 4. Regulatory Capital Requirements Figure 4 shows how the four major banks CET1 ratios compare to the regulatory minimum ratio of 8%. Importantly for hybrid investors the regulators have made it clear that their preference is for Common Equity (CET1) capital ratios to be derived from ordinary equity rather than hybrids. APRA noted on the 29^th of January 2016 that Australia’s biggest lenders raised over $20 billion of capital in 2015 to meet new capital rules. In comparison, 2016 hybrid issuance has been only ~$6 billion and this should limit market oversupply over time. Figure 4. Major Banks’ CET1 Capital Ratios Source: Company Pillar 3 Reports (30 June 2016) On a side note, we are now starting to see the major banks issue Tier 2 subordinated notes over Tier 1 hybrids due to cheaper funding costs (Figure 5). Figure 5. Major Bank Capital Structure Credit Curves Source: BondAdviser as at the 15^th of September 2016 Conclusion Over the course of 2016 institutional and retail investors have shown strong demand for major bank hybrids, supporting both the primary and secondary markets. This has resulted in a number of issues trading above their initial capital price. Of concern, however, are the large cornerstone investments undertaken by institutional investors. As institutional investors remain committed to a buy and hold approach this should not cause an oversupply of hybrids into the secondary hybrid market but if this strategy is challenged (e.g. if risk committees were to start pressuring portfolio managers to reduce hybrid positions should another banking crisis occur) trading margins could rise rapidly. New investors during 2016 have had a good ride so far but should remain vigilant as the probability of receiving a 100% return of your capital at the expected maturity date (and the income stream over the journey) remains relevant. Hybrid investors need to be aware of the different drivers of market volatility (fundamental or technical) and appreciate how they may (or may not) influence margin movements. Although margins have contracted hard and fast from recent highs, demand/supply dynamics and the current interest rate cycle remain supportive of further margin contraction (although the pace of the rally may have already begun to slow). Overall, there is still opportunity to generate returns in specific securities.