Income Report / Income Report: Is a change of Government a risk for Hybrid’s?

By Market Matters 06 March 19

Income Report: Is a change of Government a risk for Hybrid’s?

Market Matters Income Report 6th March 2019

The market is trading around 0.4% higher around lunchtime thanks largely to a weaker than expected GDP print just out at 11.30am. For the December quarter, Australia grew at just 0.2% versus 0.3% expected dragging the annual rate down to 2.3%. That increases the chance for an interest rate cut which is supportive of the market – hence the rally in stocks and the sell-off in the AUD, the latter  trading down to 70.60c post release. While slower growth should equate to lower earnings for Australian corporates, and we have seen that through recent reporting, the sugar hit from lower rates is the main driver at the moment – which is dangerous.

Dividends continue to flow following reporting season, including Perpetual (ASX: PPT), which we own in the income portfolio, letting go of $1.25 fully franked today. The two CBA hybrids also held in the portfolio, CBAPF & CBAPG, also go ex for $1.02 & $0.94 FF respectively.

ASX 200 Chart

The past week saw the Income Portfolio up by +0.88% with the help of 4 dividends being paid through the week – MXT, NBI, GMA & WBCPD. 3% gains from TLS & BOQ (which we only added to the portfolio last week) also helped the portfolio. In the current financial year, the portfolio is up 4.48% vs the benchmark (RBA + 4%) which is tracking at 3.61%, while the accumulation index has managed just 3.2% in the period. Since inception (5/7/2017) the portfolio is up +11.72%, outperforming its benchmark (RBA Cash plus 4%) at +9.16%.

The portfolio is now defensively skewed with a higher proportion of funds sitting in Income Securities relative to stocks (when including the NAB & MQG hybrids which have been added, but are not yet trading). That will change if markets pullback from here, however on a risk adjusted basis, a bias towards  income securities for this portfolio currently makes sense.

Is a change of Government a risk for Hybrid’s?

During February two new hybrids were issued with NAB raising $1.65b while Macquarie Group jumped on their coattails and raised $750m. While NAB was a rollover for an existing security, they also took new money  and any meaningful new issuance will generally take demand out of the listed space – which was the case during February. The median margin across financial hybrids widened 32bps to 3.52% from 3.20% - that was partially an unwind of some strong performance recently, however when a big 4 bank issues (albeit a longer dated note) at 4% over bank bills it does flag that maybe 3.20% over is too tight.  Bidding into both books across our desk (and the market generally) was incredibly strong implying that the market is not yet concerned with a likely change in policy under Bill Shorten.

To recap, under a Labor Government which is likely in May, they plan to remove cash refunds for excess imputation credits – or in other words, those in a no / very low tax environment who get a cash refund from the ATO will no longer get it unless you’re a government supported pensioner, a charity or can take advantage of a few other carve outs. In general terms (and we stress general) a SMSF investor with a balance of $200,000 to $1 million will lose income, and the hybrid market would likely become less attractive for this cohort.

Actual demand for hybrids is a good first indicator of whether or not the market (as a collective) is concerned about this looming change. When the policy was first announced, we did see hybrid spreads move wider (implying lower demand), from low 3’s to mid 3’s (in addition to the bank bill rate), similar to the move we’ve experienced in February with the issuance of two new notes – in other words, the market was impacted, but not materially so.

Supply is obviously the other side of the equation. While we expected NAB to roll, MQG was a surprise issue. We saw both CBA and WBC refinance issues at the end of last year ( both at a 3.70% margin) for similar duration notes and the only other major one I can see is the IANG which has $550m on issue and is due in December 2019. There is an AGL note due in June 2019 worth $650m which they intend to redeem (as outlined in their recent results) and a Tatts Bond due in July worth $192m however that will also be paid out. MM’s view is that the perceived lack of supply of new hybrids over the next 12 months is the major driver of the current demand we’re seeing, and it implies that even under a Labor Government there is enough demand outside of the impacted cohort that will keep the market fairly well supported.

Although somewhat of a dark science, research shows that the SMSF investor base into franked hybrids is estimated at around 10 to 15% of the total investor set. While it’s very hard to pin point the likely reaction of investors when changes are made, looking at 1. Demand since the proposed change was announced 2. Low supply over the next 12 months 3. the relatively small proportion of holders that will actually be impacted, clearly suggests that the impact, if any, would be small.  

As we’ve written in the past, simplifying things can actually be the best approach – the KISS strategy – and looking at where tier 1 bank hybrids as a group typically trade in terms of margin over the bank bill rate over time, and with varying external influences we can see where  the floor and ceiling in the market generally is. As a rule of thumb for Tier 1 major bank securities, a 4% margin means the security is cheap and a 3.00% margin means it’s expensive – that is what history has shown, with the average since 2012 for financial hybrids at 3.60%.

We know that the recent NAB deal saw a $200m cornerstone investment from Unisuper – which is big, and that’s not the only time they have stepped into the market. Back in April of 2016 when credit markets were shaking and the equity market had just traded as low at 4800 (ASX 200), CBA issued a tier 1 hybrid at 5.20% over bank bill, and again, Unisuper went hard on that deal.

So in answer to the original question, is a change of Government a risk for Hybrids, the answer is we doubt it. It may be a short term negative, and yields could increase as they did when it was announced however in my experience there are always other market players that could / will fill the void if pricing becomes attractive.

Right now, a 4% margin has enticed a large institutional whale into the room – when things were less certain globally, and credit markets were risky, it was a margin of 5.20% that enticed them in. I very much doubt, if the research is correct, that 10-15% of hybrid holders that will be impacted by the proposed change will have a hugely detrimental impact on the market. We remain keen on financial hybrids and have 30% of the Market Matters Income Portfolio exposed to them.

Metrics Credit Partners – launches a higher risk offering

We currently have the MCP Master Income Trust in the MM  Income Portfolio having added it during the IPO around 12 months ago. This Listed Investment Trust (LIT) from Metrics Credit Partners invests in the Australian corporate loan market aiming to provide investors (us) with a return of the RBA cash rate +3.25% - which currently equates to 4.75% - although after today’s GDP print there’s a good chance that return objective will be amended lower.  They’ve done well and delivered what they have set out to do  in the first 12 months.

In the last few days ‘s they’ve launched a new offering, which I’ll cover in more detail after meeting with the managers – however it’s a higher risk, higher return trust that can invest more broadly across the private credit spectrum. They target a total return of 8-10% per annum and below it quick graphical that outlines the differences  risk v return spectrum.

We will cover in more detail after meeting with the company – the offer opens on the 12th March

Conclusion (s)

We doubt that a change in policy will have a meaningful impact on the listed hybrid market – in any event, when yields become attractive other participants will fill the void
We remain keen on financial hybrids at a margin around 4% over bank bills.

Currently listed securities that offer value at that level include

WBCPH trading on a margin of 4.01% over
BOQPE trading on a margin of 4.03% over
SUNPG trading on a margin of 4.13% over
BENPG trading on a margin of 4.02% over

Have a great day!

James / Harry & the Market Matters Team

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, or after the session when positions are traded.

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