Income Report / Searching for opportunities in the Hybrid space

By Market Matters 06 September 17

Searching for opportunities in the Hybrid space

Searching for opportunities in the Hybrid space

The MM Income Portfolio had a tough week, dropping 1.32% in terms of capital but less so if we include the benefits of dividends. The drop was largely a result of a big sell off in Harvey Norman (HVN) post their report, which was good in terms of the headline numbers however the market remains sceptical of their accounting policies + Q4 sales momentum seemed to slow. The stock is now marginally lower than when we purchased and we’ve given back a nice open profit - however for now, we’ll hold tight.

Elsewhere, today we sold out of Wesfarmers (WES) locking in an all-in return of ~7.8% and will look to allocate 5% into the MCP Trust shortly.

Income Portfolio – capital moves over the past week.

Overall, the portfolio has gained 0.38% since inception and dividends are now starting to flow - we remain comfortable with the composition of the portfolio in a range bound – soggy market with the ASX 200 down by -1.28% since portfolio inception

Searching for opportunities in the Hybrid space

There was an interesting article by Chris Joye in the AFR last week titled, Why Bank Hybrids are worth the risk, sourcing work from Dr Sam Wylie of the Melbourne Business School. It was a very good article and provided a detailed look at valuing these more complex securities. A lot has been written / spoken about Hybrids in the media, and even the outgoing  ASIC Chair Greg Metcraft recently labelled them ‘ridiculous’ for retail investors given their complexity, however it’s refreshing to read a more level headed analysis of the securities, some of which we hold in the MM Income Portfolio.

At MM we are very conscious of having an open mind and assessing investments based on their merits – with the concept of risk versus return at the forefront of our minds. Firstly, Hybrids are not cash, they have conditions in them that can force the issuer to convert them to equity in extreme circumstances, and they will be more volatile generally than a bond that sits higher in the capital structure, however as always, an investment is all about assessing the likely return relative to the risks of the underlying security and importantly, whether or not we are paying ‘overs’ or ‘unders’ for the return.

I won’t go into the details of the suggested pricing model outlined in the article however the article does focus on Commonwealth Bank Hybrids, which is timely given the woes CBA is currently experiencing. In terms of the conclusion of the article,  Wylie argues that "bank hybrids' reward-to-risk ratio, and their defensive qualities, are so attractive that investors should consider [them] despite their complexity". He is right that hybrids can be defensive vis-à-vis ordinary shares. Over the last 12 months the hybrid Wylie focused on, CBA'S Perls VII (ASX: CBAPD), has displayed one-third the volatility of CBA's shares. Wylie developed a model that conceives of a hybrid as a "combination of low-risk bonds plus embedded put options". Doing so allows him to conclude that "CBAPD investors are getting a yield of about 1.30 per cent annually more than is justified by the risk they are taking". (source; www.afr.com.au)

In terms of the existing stable of CBA listed bank hybrids, namely CBAPC, CBAPD, CBAPE & CBAPF, all have traded ex-dividend today – so are down to reflect the distribution coming out of them, however to us, there is clearly value there – particularly in the PD’s.

*prices as at COB 5/9/2017

As shown above, the shorter dated securities pay less, the longer pay more in terms of yield to first call date, which includes dividends, franking & any capital gain / loss to get back to the $100 face value, however the shorter dated are lower risk and generally less volatile. The CBAPD is probably the most well-known security  and is generally thought of as the hybrid that sank the market, with a huge $3bn issued at a skinny 2.80% over the bank bill rate. I’ve been in the market for a long time now, been involved with hybrids for over a decade, and this was by far the offer that attracted most demand…the biggest issue at the lowest margin saw the most demand  – and CBA couldn’t help themselves but print it!  Interestingly enough, they now trade at $96.50 after going ex-dividend today for 79.75 cents, which is their quarterly distribution.

Over August the average margin across ASX listed CBA hybrids widened from 3.08% to 3.40% - meaning prices have fallen on the back of the AUSTRAC anti money laundering allegations and the subsequently announced APRA enquiry into CBA’s governance, culture and accountability. The past few days have seen CBA hybrids dominate volumes, as some investors exit or reduce holdings, while others take the opportunity to invest at cheaper levels/higher margins. As suggested above, the CBAPD has actually had 1/3 the volatility of CBA shares, while still paying a solid grossed up yield of +6% - something worth considering.

CBAPD – Weekly Chart

If CBA hybrids are being sold off due to regulatory issues with the bank, we must ask ourselves whether or not the regulatory issues will have such a meaningful impact on earnings that CBA could stop paying dividends on its underlying shares – and therefore open the gate to stop paying on the Hybrids. At this stage we tend to think that the re-rating of CBA is more of an equity phenomenon as the market strips out their ‘can do no wrong’ premium versus the other banks, while mean reversion normally prevails in relation to  major bank hybrid spreads, so therefore prices should recover. We agree with the article discussed above, thinking that CBA hybrids, particularly the PD’s represent good value at current levels.

Wesfarmers (WES)

We sold out of WES today after picking up the dividend, franking and some small capital gains. This is primarily to increase cash in the portfolio to take advantage of market weakness if it prevails. The Income Portfolio took a profit of ~7.80% inclusive of franking.

Wesfarmers Daily Chart

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 Wednesday.

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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 06/09/2017.  11.00am

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