NEWS + VIEWS – 20/09/2024
MARKETS
In an example of ‘be careful what you wish for’, markets are uncertain at what a large 0.5% interest rate cut by the US Federal Reserve means for the economy. Most analysts were expecting a 0.25% cut as inflation was softening and US GDP growth was still a very healthy 3.0%. Fed Chair Jerome Powell stressed that the outsized cut would be followed by smaller reductions at a leisurely pace.
Analysts and investors like to think of what could go wrong from here (e.g. the US economy weakens or inflation breaks out again) and compare it to what can go right. Markets have had a good run of late trading around record levels and high Price/Earnings ratios, therefore an element of caution is warranted. As usual, the future is uncertain, so asset allocation and investing in quality companies remains key.
APRA PROPOSES TO PHASE OUT BANK HYBRIDS
The Australian Prudential Regulation Authority (APRA) has updated the ‘progress’ of their review of bank hybrid securities and the proposition to phase them out. Its concern is that bank hybrids are significantly held by retail investors and that, in the event of a bank crisis, it would not be politically possible to write off the hybrids (i.e. the government would intervene to block the write-offs).
APRA points to last year’s collapse of Credit Suisse. It is difficult to reconcile APRA’s view in that the Credit Suisse hybrid holders were wiped out before equity holders. The Swiss regulators were so keen to get a UBS takeover of Credit Suisse across the line that they reversed the order in which priority is given to hybrid holders over shareholders, which seems more of a regulator risk than a hybrid risk.
One would have to ask whether APRA’s proposal will push retail investors to hold more higher risk bank shares to maintain their cash flows. Nevertheless, APRA’s wish is that all bank hybrids be replaced by 2032. Consequently, the market may not see another bank hybrid issue. APRA has said that it will allow existing hybrids to be counted as part of the banks’ Tier 1 capital, so there will be no imperative for an early call on these hybrids. APRA has requested feedback over the next two months.
The chart below from Mason Stevens shows the upcoming call (usually maturity) dates for hybrids. There will be a significant ‘dent’ in listed bank hybrids by the end of 2025.
Source: Mason Stevens
Assuming APRA decides to proceed with the proposal, then it is difficult to determine how it will affect prices of existing hybrids. Recently, prices have been rising (and yields declining for buyers). However, as investors move their focus to other securities, we may find that liquidity starts to decline (i.e. less buyers and sellers). This is not necessarily a problem for existing holders prepared to hold the securities to maturity but may impact an impatient seller as the spread between buyers and sellers widens.
Mason Stevens has set out a list of some alternative investments (see chart below). Hybrids have been offering a yield to call/maturity of between 5% to 7%, which takes into account the interest payment, franking credit and capital loss/gain. However, those returns can be lower depending on what yield curve (future interest rates) eventuates as the returns are tied to the official cash rate determined by the Reserve Bank of Australia.
Data from Bloomberg September 2024
* Net Asset Value performance used for LITs
** As at end of July
Some clients will be familiar with the Australian Hybrids Fund (HBRD) and the Australian Major Bank Hybrids Index ETF (BHYB), which both invest in bank hybrids. Another Exchange Traded Fund (ETF), the Australian Major Bank Subordinated Debt ETF (BSUB) provides exposure to subordinated notes issued by the major banks. Subordinated notes rank higher than hybrids and equity, so are regarded as having less risk. Consequently, the returns are usually lower than those of hybrids.
The ETF manager may derive greater profits by trading securities but as their costs need to be covered, there is a management fee. However, BSUB’s is a low 0.29% p.a.
In summary, there are alternatives to investing in bank hybrids although it may require using ETFs and/or Listed Investment Trusts (LIT).
Gerard O’Shaughnessy
P 0423 771 330
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