National Australia Bank and Macquarie Bank withdrew hybrid security offers late last week, citing market volatility and the likely impact on the price of the notes once they listed.
NAB launched a hybrid offer, NAB Capital Notes 4, on February 25, seeking $1.9 billion of capital. It will refund all the money raised.
In a statement last week, NAB said 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].”
Macquarie withdrew its $500 million offer of Macquarie Capital Notes 2, saying it made the decision “in light of significantly changed market conditions in recent weeks.”
Both banks said they would repay investors in old capital note issued that had reached their call dates. And both banks emphasised that their capital positions were strong.
Hybrid securities have been popular with retail investors in recent years because they are issued by banks, in the main, and offer relatively high yields.
NAB was offering a margin of 2.95 per cent above the bank bill rate on its capital notes. Macquarie was offering a margin of 2.9 per cent over bills on its issue.
Hybrids combine features of debt and equity securities and they involve higher risk than traditional fixed income investments.
The banking regulator APRA imposes conditions on the issue of hybrids if banks want to count them as part of their regulatory capital.
Distributions on capital note are discretionary and they typically have a perpetual term rather than a fixed maturity.
They can be converted into equity by the issuer, investor or regulator if certain trigger events occur. These events include a fall in a bank’s level of regulatory capital or 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.
In NAB’s case, its hybrids will convert when its capital falls below a pre-determined proportion of assets, if the bank is judged to be “non-viable” or if it suffers big losses.
With the markets in turmoil, investors have turned their attention to the equity characteristics of hybrids. Most of the capital notes listed on the ASX are now trading below their $100 face value – some of them well below.
Commonwealth Bank has six interest rate securities currently listed on the ASX. They are trading between $88 and $99 – all below their $100 issue price. It’s much the same story for other issuers.
Back in 2016 Kevin Davis delivered a paper at tan Actuaries Institute conference in which he said: “We face problems with these instruments. We haven’t got a clue.”
Davis 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.”
The Australian Securities and Investments Commission has been warning for years that investors do not understand the risks they take on when they invest in hybrids. ASIC has said it is concerned that investors do not understand that maturity dates on hybrids can be deferred, sometimes in perpetuity, that dividend or interest payments can be cancelled and that the market value of the securities can fall.
In a 2017 interview, former ASIC chair Greg Medcraft said hybrids were a “ridiculous” product for retail investors. Medcraft said hybrids had been banned in the UK and other markets.
The same year, Standard & Poor’s downgraded big bank hybrids, dropping them below investment grade. And in June Europe’s Single Resolution Board cancelled all the shares and hybrids of Spain’s Banco Popular in response to the bank’s failure.
Hybrid securities, which can be included as additional tier one or tier two capital, had to offer non-cumulative distributions, which means that if the issuer misses a distribution payment it does not carry over to the next distribution period.