An interesting article caught my eye today. The outgoing Chairman of ASIC, Greg Medcraft, gave an interview to the AFR to discuss his six and a half years as chairman. Along with some interesting discussions on banking profitability and a willingness to go after banks in interest rate rigging cases, the major thing that caught my eye was his discussion of hybrid securities, particularly for individual investors.
Mr Medcraft said that hybrids are a “ridiculous” product for retail investors, and noted that they had been banned for retail investors in markets such as the UK. I’ve talked briefly about hybrids before, and I thought I’d take the opportunity to flesh out the discussion a little more today.
The other relevant development since I last wrote about hybrids has been the treatment of additional tier 1 hybrids in Spain recently. Banco Santander agreed to take over Banco Popular, following determinations by European regulators that Popular Espanol was likely to fail. Santander acquired Popular for 1 euro, after all common equity; the hybrids outstanding and tier 2 insturments were wiped out. Europe’s single resolution board slashed common equity to zero, Additional Tier 1 to zero, converted tier 2 into equity and then sold that equity for 1 Euro.
This was essentially exactly how hybrids and tier 2 instruments are expected to act – the first layer of additional equity following common equity. The wind-up is relatively orderly and highlights the expected resolution of failing banks that have existing hybrid issuance.
Risk premium relativities:
Its important to note that in the Popular incident, both hybrid holders and tier 2 instrument holders were wiped out. (Technically, holders of the tier 2 instruments get to split the 1 euro amongst themselves.) A key question for investors in hybrids is the appropriate risk premium for these instruments. A word of warning here – we are veering off into financial theory and bond market stuff. Its not super difficult, but it can be dry!
Risk premium is the return investors expect to get above the risk free rate for investing in a riskier asset. The theory states that less risky instruments should deliver lower returns; we see this with listed subordinated debt trading at lower yields than hybrid securities. This is because subordinated debt sits higher in the capital structure.
Over the last 100 years or so, data shows that the risk premium for equities has been about 4% (or 400 basis points) – we could quibble with the number here (and many people seem to make an academic career out of doing so) but rather than talking about the absolute number, we are focusing on the relativities. Given equity is lowest on the capital structure, we would expect that the returns to equities are higher than instruments that sit above it on the corporate structure.
And basically, that’s what we see currently. Additional tier 1 hybrids from Australia’s big banks and Macquarie trade at trading margins of approximately 3.1-3.3% depending on the time to first call.
Valuation of Hybrids and long term premiums.
The question then becomes: at what trading margin do hybrids represent fair value, given recent history shows that the recovery of these instruments in distress periods is zero? Well, as a baseline, five year average spreads for AT1 hybrids have averaged 3.57%, while listed subordinated has averaged 2.1%. (5 year bank senior debt trades at 0.93%, on average).
If equity premiums over the last 100 years have averaged 4%, would a trading margin or 4% represent excellent value? Well yes, and no.
The reality is, for an instrument that sits above equity in the capital structure, a 4% trading margin in and of itself is very attractive. But, when compared to equities, the periods in which AT1 hybrids have reached 4% trading margins have seen very attractive estimated risk premiums on equities, over and above the long term average
What does this mean? Whenever hybrids are very attractive, equities have also been very attractive. And equities deliver higher long term returns than hybrids, on average. No surprises there.
My long standing opinion is that equities provide a long term way to accumulate inevitable wealth. Clearly, a significant tilt to equities makes sense, and in my opinion, in almost all instances. However, there may be periods in which an allocation to a diversified portfolio of hybrids may make sense. For those wanting to lower their volatility, there are periods in which the margins from hybrids will closesly approximate the long term risk premium from equities.
This may provide an attractive time to build a diversified portfolio of hybrid securities for investors.
Perhaps I’ll leave the last words to two people who have produced a large amount of research on hybrids for domestic investors, Campbell Dawson and John Likos:
“Hybrids can be an appropriate part of an investment portfolio. Notwithstanding the well explained and well understood risks there is an attractive risk return profile for the well diversified investor.”
“I don’t fly the banner for hybrid securities. They are not fixed income, they shouldn’t be treated as a bond or a term deposit but hybrids can be an excellent investment if you understand the risk and are willing to take that on.”