Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Hybrids are back, and paying higher yields
The hybrid securities market felt the brunt of the COVID-19 crisis in March, when two issues were withdrawn and another issuer deferred redemptions. But last week Macquarie Bank relaunched its hybrid offer, offering a substantially higher margin than the rate on offer a few months ago.
Macquarie Bank Capital Notes 2 was originally launched on February 11 but was withdrawn on March 13, with the bank citing “significantly changed market conditions.”
Under the terms of the original offer, Macquarie was seeking $400 million of capital, paying a margin of 2.9 per cent over the bank bill swap rate and with a first redemption date of December 2025.
Under the terms of the revised offer, Macquarie will pay a margin of 4.7 per cent over BBSW. The redemption dates are unchanged.
The re-pricing reflects that fact that demand for hybrids has softened and many are now trading below their issue prices. The withdrawals and redemption deferral have made investors wary.
Other terms of the offer are unchanged. Macquarie Bank Capital Notes 2 are perpetual, unsecured, convertible subordinated notes which qualify as additional tier 1 capital for the bank.
Distributions are discretionary and non-cumulative and are expected to be partially franked.
The notes may be redeemed on December 2025, June 2026 or December 2026, and they have a mandatory conversion date of December 2028.
Fixed income researcher BondAdviser has rated the issue “subscribe,” saying it expects the securities to be well-supported.
BondAdviser says: “Overall, our relative value analysis suggests this security is offered to investors at a margin offering a substantial premium versus similar offerings over the past few years but which also incorporates higher market risks over the near and medium-term.”
There has been plenty going on in the hybrid market over the past couple of months. NAB also withdrew a hybrid issue: the offer was launched on February 17 but withdrawn on March 12.
NAB said that market conditions “have changed substantially since the offer was launched and that the ongoing market volatility would be likely to impact on the trading value of the [notes].”
Both Macquarie and NAB said they would repay investors in old capital note issues that had reached their call dates.
Late in March, wealth manager Challenger cancelled plans to launch new a hybrid security issue, which it was to have used to redeem its current issue of Challenger Capital Notes. It pushed out a repurchase of the hybrids by up to two years.
The $345 million of notes have a call date of 25 May this year and a mandatory conversion date of 25 May 2022.
Challenger received approval from the banking regulator Australian Prudential Regulation Authority (APRA) to repurchase the notes on any quarterly distribution payment date up to the mandatory conversion date.
In the meantime, noteholders will continue to receive quarterly distribution payments. The notes will continue to be traded on the ASX.
Hybrid securities have been popular with retail investors in recent years because they are issued by banks mainly, and offer relatively high yields.
They are a bit like term deposits. But hybrids combine features of debt and equity securities and they involve higher risk than traditional fixed income investments.
APRA imposes conditions on the issue of hybrids if banks want to count them as part of their regulatory capital. Distributions on capital notes are discretionary and they typically have a perpetual term rather than a fixed maturity.
They can be converted into equity by the issuer or the regulator if certain trigger events occur, such as a fall in a bank’s level of regulatory capital or a situation where a bank encounters severe financial difficulty. These conditions are sometimes referred to as “bail-in” provisions.
When such events occur, hybrid holders are likely to receive shares that are worth significantly less than the face value of the hybrids they have bought.
With the markets in turmoil, investors have turned their attention to the equity characteristics of hybrids.
Back in 2016 Kevin Davis, professor of finance at the University of Melbourne, delivered a paper at an Actuaries Institute conference in which he said: “We face problems with these instruments. We haven’t got a clue.”
Davis, who was a member of the 2014 Financial System Inquiry, said bail-in conversion may or may not expose security holders to a loss on the face value of their hybrids, depending on the issuer’s stock price at the time, and conversion may be partial or full.
“Appropriate pricing requires the ability to model the risks of such securities, using some form of asset pricing model. However, bail-in securities include imprecise specifications of the trigger event and imprecise specification of the actual conversion arrangement. This makes modelling difficult,” Davis said.
“Bail-in securities are more appropriately characterised as involving uncertainty rather than risk that can be modelled.
“Bail-in is a new type of risk and it would be expected to attract a risk premium, compensating for the risk that the securities could be converted to equities or written off. Because of the opacity of the risk involved, there may be little conversion risk sensitivity in the pricing,” Davis said.
