Views at a Glance / Income Report; A deeper dive into Hybrids

By Market Matters 12 July 17

Income Report; A deeper dive into Hybrids

Market Matters Income Portfolio 12/07/2017

A week has passed since we launched the Market Matters Income Portfolio and lots of questions have flowed, primarily around Hybrids, their potential roll in an income portfolio, and importantly the risks / opportunities as we see them. We’ll get on to that shortly, however first up, let’s have a quick review of the current income portfolio . We have 50.5% allocated to equities, 27.5% allocated across four hybrids and 22% held in cash for now, awaiting further opportunity. For the week, the portfolio is up by 0.7% with the gains coming from capital appreciation rather than income. The ASX 200 has fallen -1.1%, however it’s not a valid comparison given the composition of the income portfolio – so it will not be referred to in future (in terms of this portfolio!). On the horizon, we have dividends coming up from SUN, CBA and ANZPD.

To recap – here is the portfolio, and this is available, in a slightly different format on the website at any stage during the week by CLICKING HERE – or by navigating to the Market Matters Portfolios menu bar through the Reports Tab.

In terms of the portfolio, a couple of stocks worthy of mention.

AP Eagers (APE); Released first half results this morning booking a net profit before tax of $68.1m, which is marginally higher than this time last year (+0.3%). The market liked the result and the stock was trading up  +5% at time of writing (which is not reflected in the portfolio returns above), largely because the result was ahead of the downbeat guidance the company recently provided. That guidance was for a decline of between 7-9% below last year’s result, however clearly this has not played out as expected. We continue to like AP Eagers (APE) for income with some potential for further growth.

AP Eagers (APE) Weekly Chart

Alumina (AWC); Has moved higher over the week however continues to see some resistance around the $2.00 mark. It’s rare to find a resource related stock with (in our view) such a positive outlook for both income and growth. The usual caveats do apply in terms of volatility in earnings, however a close above $2.05 should open the gates for further gains towards ~$2.50.

Hybrids

There’s a very good overview of Hybrids released by the ASX (click here to download) and we’d encourage all who look to invest in Hybrids to  review it.  We’re not about re-hashing already available information so we’ll now assume you have a better knowledge of the product. From that point, we need to be conscious of the ‘drivers’ of Hybrid prices, and importantly managing the balance between risk and reward. In the hybrid market, the risk component has a few different elements.

We need to think about the external environment, what might happen to impact the risk premium investors are happy to receive to take on a given exposure. For instance, if the market are extremely calm, and there is little perceived risk on the horizon, investors may be happy to receive a small margin over cash as compensation. However, if risks (or perceived risks) are high, then that premium would need to lift to attract buyers. The yield would need to be higher, and to get a higher yield, the price of the security has to go down.

In terms of the external environment, at this point higher interest rates globally is a theme we’ve discussed at length - we therefore should ask ourselves, what does that mean for hybrid investments? Most hybrids are floating rate notes, which means they pay a premium over a particular rate, such as the 90 or 180 Day Bank Bill Rate, and that rate moves up as interest rates rise. Therefore, the first observation is that we should be invested in Floating Rate Securities rather than fixed rate securities and that will offer  relative insulation against rising interest rates. That said, if we do see higher rates (and we are), higher rates are normally accompanied by some widening in credit spreads,  however this is partly offset by the switching that occurs from fixed rate into floating rate securities at the time rates start to go up.  So without going into too much detail, we remain comfortable with floating rate  Hybrids as interest rates rise, albeit we need to remain vigilant.   

We also must consider the credit worthiness of the issuer. For instance, a Suncorp Hybrid will pay 5.74% versus an ANZ hybrid which will pay 5.12% for similar duration (4.9 years vs 4.7 years to first call date or maturity). Is the credit quality of ANZ that much better than the credit quality of Suncorp? We need to make an assessment in this regard. We then look at the structure of the Hybrid, whether it is a new Tier 1 bank hybrid, a subordinated note or even a perpetual security such as the NABHA. This will have a significant bearing on the volatility of the hybrid, the income that it pays, the certainty of income and importantly, how you will get your capital back at maturity.

The other issue is around ‘triggers’ within each security. A Tier 1 Bank Hybrid will have a couple of ‘triggers’ to satisfy the regulators. The triggers are around capital and non-viability, which is determined by the regulator, however they increase the risk of the security over and above a security without the triggers.

We then need to think about duration. The longer the Hybrid has got before its call date (maturity), the higher the chance something can go wrong. This generally leads to higher volatility on the market, and should also lead to a higher yield for holders.

2 examples here to highlight the points above – both from the same issuer, and both with similar structures

WBCPD: Last price $100.50; 4.89% Grossed Yield to 8 March 2019 (1.7yrs)
WBCPG; Last price $106.00: 5.81%  Grossed yield to 20 December 2021  (4.4yrs)

A high yield for longer duration.

If we then compare similar durations from different issuers.

ANZPD; Last price $102.51; 5.25% Grossed Yield to 1 Sep 2021
BENPF; last price of $102.00; 5.74% Grossed Yield to 15 June 2021

We then distil all of this down and make a call in terms of both the individual security and how that stacks up relative to the above, but also how the security fits with its friends in the portfolio, mainly around duration and credit quality. In terms of duration, we would want a nice maturity profile so we don’t have 5 securities maturing in say a 6 month period, but rather securities maturing over a suitable time period.

It’s a reasonably complex area, and takes time to understand, however if managed correctly, Hybrids can be a very good addition to an income portfolio

Conclusions

  • Nothing new to add to the portfolio at this stage, however a number of opportunities remain on the radar
  • AP Eagers has been a strong performer to date, adding +6% today on good earnings numbers
  • We will look to increase out exposure to CBA into further weakness ahead of the dividend in August

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday.

Disclaimer

All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 12/07/2017.  11.00AM.

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