Views at a Glance / Income Report; Property Stocks & Hybrids – what happens if Shorten actually gets in? (WFD)

By Market Matters 04 April 18

Income Report; Property Stocks & Hybrids – what happens if Shorten actually gets in? (WFD)

Market Matters Income Report 4th April 2018

According to Sportsbet, Labor are short odds to win the next election ($1.37 versus Coalition at $3.00) so the recent attack on cash franking credits is clearly a live issue. We covered the detail in an income report a few weeks ago (click here) and since then Shorten, after considerable public backlash has watered down some of the key terms – the main one being that the policy with now make an exemption for all Australians on the age pension. Firstly it seems ludicrous that this consideration was not made before such a monumental policy was announced – not considered nor discussed and its impact actually downplayed in the initial ‘selling spiel’, nonetheless, they’ve changed it now and it seems the betting agencies at least show the policy blunder has not had any real impact on Labor’s chances of dethroning Mr Turnbull from the Lodge.

There are two interesting extremes from an investment standpoint in this debate. Many income focussed investors have exposure to Tier 1 hybrids – which are the newer bank issued notes and they will be impacted negatively by the proposed amendments to franking, while unfranked property securities will, in a relative sense become more attractive. We look at both areas in this week’s income note.

In terms of the MM Income Portfolio, the portfolio was down -0.81% over the short week, although the ASX 200 was off by -1.38%. Since inception (5/7/17) the portfolio has gained 4.165% tracking above the market and above the portfolios benchmark. (cash rate + 4%).

Franking Credits

While tax matters are always best left to tax experts, for this discussion it’s important to understand the concept of franking credits and how that  feeds into total income. In the case of Hybrids, because they are partially debt instruments the franking component is included in the yield number. Best to look at an example here with a Hybrid yielding 6.00%  (6.00% x (1- corporate tax rate)) per year or 6% x 0.7 assuming a corporate tax rate of 30%. In this instance,  the cash distribution would be $4.20 and the franking benefit would be $1.80 claimed back at tax time as either a cash refund or used to offset tax payable depending on the prevailing circumstances (and policy at the time). For a fully franked share, the dividend is quoted ex the franking and to calculate the grossed dividend we simply divide the dividend by 0.70, again on the assumption of a 30% corporate tax rate. A 6.00% yield fully franked for an equity equates to 8.57%.

In terms of property stocks, these offer largely unfranked yields given their stapled structures (which we won’t go into), so a 6% unfranked yield for a property company remains just that – 6%. However, when considering an individual earning 6% franked on an Aussie Tier 1 hybrid that pays no tax will (assuming Shorten gets in and gets these measures through the minefield of the Senate), will see that income drop to 4.20% without any real chance of sustained capital growth, meaning that in relative terms at least, property stocks become more attractive.

Property Stocks

Property stocks will benefit if Shortens franking credit policy gets up –  offset by the impost of higher interest rates, however the obvious question is, have higher rates already been factored in? The metric here from our perspective is the spread over interest rates – or specifically, the spread over 10 year bond yields. As it stands, the spread sits at 2.75% which is still below the 3% average. Or in other words, the sector has an average yield of 5.4% with bond yields sitting at 2.65% = spread (or risk premium) of 2.75%. The average of 3% is actually skewed somewhat by the GFC so the real number is lower than 3%. Here’s the chart highlighting it;

The other worthwhile metric is around the price relative to the value of assets. A number of property plays are trading at a steep discount to underlying assets which is clearly attractive, however higher rates have a negative impact on the underlying asset values (& gearing). Rising interest rates generally correspond with rising rents so there is a natural offset to some degree – however rents need to be rising.

We track the following property plays and clearly there are some big variances in metrics.  The companies with funds management divisions like Goodman (GMG) are trading at big premiums to NTA, while most REITS with a Retail sector exposure are trading at a discount (including SGP, GPT, SCG, CQR and VCX) – which is not really surprising given the heat most retail operations are facing which has a flow on impact on the ability for landlords to jack up rents to offset the impost of higher funding costs.

Here’s a table for review;

We hold one property stock in the MM Income Portfolio – Vicinity Centres (VCX) and it’s one of the weakest holdings, showing a paper loss of ~9%. The stock was ‘cheap’ when we bought it and certainly remains that way trading at a big discount to the value of its assets, however it’s an example of why going against the macro backdrop to target value can be problematic – sort of like swimming against a rip in the surf. While we don’t like sitting in the red on a holding, and we don’t like the property sector from a thematic standpoint (given rising rates), the stock is trading at an 18% discount to NTA, a 6.7% unfranked yield with no value being ascribed to its funds management business + it’s got a share buy-back which is yet to kick in (not sure why it hasn’t). The key issue seems to be its sensitivity to rising rates.

For now though, we think there is value in some parts of the sector but really, the outlook for rates means we have very little interest overall.

Vicinity Centres (VCX) Chart

 

Update on Westfield (WFD); Last week, WFD announced that the proposed acquisition by Unibail-Rodamco has received Foreign Investment Review Board (FIRB) approval. While we don’t own WFD we know a lot do – to use as a guide only below is an estimated mark-to-market of the Unibail-Rodamco offer, being $8.98 (as at cob 31 March 2018), which compares to WFD’s closing price of $8.52  Since the proposed acquisition was announced, the Unibail-Rodamnco share price has fallen by 14% - a key driver for the market to market price of A$8.98/share being lower than the implied A$10.01/share value at the time the proposal was announced. Here’s the breakdown from Shaw’s Analyst Peter Zuk (WFD is not officially covered by Shaw)

Westfield (WFD) Chart

On the numbers below buying WFD at $8.52 with the view of selling into the bid has an implied return of 5.4%  with the stock off the ASX on the 30th May with the deal completed on the 7th June 2018*(Dates subject to change)

 

Hybrids

Hybrid securities are  clearly an area of the market that seemingly have most to lose if shorten gets elected and we’ve had a lot of questions about this through the week – so today we’ll briefly build on last week’s coverage (which can be viewed here). Morningstar published a good piece this week on the potential impact – concluding that they represent good value in aggregate after the recent sell off.

Last week we suggested that over the last few years, the market (in terms of margin) bottomed around 2.80% over and topped out around 5.20% over. Below is the move in spreads since the announcement was made by Shorten – a couple of observations here.

1. Shorter dated hybrids saw less impact which is typical given fewer variables before first call

2. From a broad brush view, the sector is trading on around a 4% margin  over the bank bill rate – which in our view offers good value here  

If this policy change does get up, a few things may happen for tier 1 hybrids which are franked. Prices will drop, however the proportion of investors that actually hold hybrids that are impacted by the change is lower than perhaps first thought (MS reckon around 20%). The other side of the equation is that Hybrids are a crucial source of funding for banks and therefore APRA may seek to follow past precedents and exempt outstanding securities from the new rules until they are replaced over the next circa seven years – if that were to happen, then prices would go up strongly.

As it stands it is currently cheaper for Aussie banks to issue hybrids into the US dollar market as a number of issuers have done. The change by Shorten will simply see less domestic issuance and therefore demand from some investors (who can still take advantage of franking credits) will increase, likely offsetting the hole left by those that can’t utilize the franking benefit.

Or, banks will stay issuing locally, and if demand has fallen, yields on new issues will  need to increase to attract buyers, and ultimately the secondary market will rebalance.

All in all, a lot of ‘ifs’ currently however the key takeaway for us, is that we’re not concerned at this stage and as it stands, 4% over for an average tier 1 hybrid looks good value here (given all the variables outlined above).

Conclusion (s)

ASX listed property stocks will be a net beneficiary of Shorten’ s proposed attack on franking credits while in aggregate, Hybrids will be overall losers in the shorter term (if it gets up)

We remain negative property stocks in aggregate given rising rates and would only consider specific value or event driven trades

Hybrids are now offering good value following the recent drop

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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