Hybrids – more to conversion risk than actual bankruptcy
When considering the risks associated with investing in bank hybrids most investors consider the key risk as being the mandatory conversion of hybrids into bank shares in the event of an actual bank bankruptcy or failure. It would appear, quite reasonably, that the risk of a major Australian bank failure occurring is low for a number of reasons. Firstly, Australian banks are highly profitable due not only to the current point in the credit cycle but also industry structure. Secondly, in comparison to many global banking systems the Australian banking system is well capitalised; i.e. has material capital buffers. Finally, with the major near term risk area in terms of lending appearing to be around investor lending for residential property, both the banks and the banking regulator (Australian Prudential Regulatory Authority or APRA) appear to have acted proactively to curb lending and manage the exposures to this sector. So overall everything is looking pretty positive for investors in bank hybrids with the potential for higher returns with little in the way of apparent risk.
Yet the devil can often be in the detail. The key for any institution which is highly leveraged, such as a bank, is solvency. Solvency is linked to, but also in some ways distinct from, other factors such as profitability and capital buffers. Solvency basically deals with the ability of banks to have ongoing access to the funds necessary to finance their loan books. Ongoing access to such funds becomes critical not only due to banks being highly leveraged but also because all banks borrow short term and lend long term (i.e. there is a duration mismatch between assets and liabilities). Such a risk can be exacerbated by a bank having a higher proportion of their total funding coming from domestic/global debt and money markets rather than domestic deposits which tend to be “stickier”. Such a risk was amply demonstrated by the Global Financial Crisis (“GFC”) in 2008 which threatened bank solvency globally and domestically via the freezing up of the global interbank market. It was only timely intervention by governments around the world, including the Australian government which stepped in to guarantee bank debts, which ensured the ongoing solvency of the domestic banking system. Importantly events which impact upon the ability of banks to access capital markets can not only occur suddenly and without warning but may also be unrelated to the domestic credit cycle i.e. can be driven purely by global events.
Complicating the picture further are changes in the decision structure regarding which party determines when the conversion of hybrids actually occurs. Prior to the GFC the process was much more clear cut with decision resting with the issuing bank. However over time APRA has moved to have a greater say in when conversion occurs and can now require conversion to occur if, in the view of the regulator, a bank would become non-viable without (a) conversion of the hybrids or (b) in the absence of a public sector capital injection or equivalent support. While there is little debating what constitutes an injection of capital by the public sector what “equivalent support” encompasses is intentionally more ambiguous. Does a government guarantee of bank debt which is required to ensure banks can maintain ongoing access to capital markets, as occurred in the GFC, constitute “equivalent support”?
None of this is to deny that bank hybrids do not appear to be at risk of being converted in the near term or that it would take anything other than an extreme event to trigger conversion. However investors need to recognise the conversion rules have changed and that conversion under the current regulatory framework is more likely. Further it does not necessarily require the bankruptcy or actual failure of a bank to trigger conversion of its hybrid securities. As with any investment the returns offered can be materially higher than alternatives but it pays to make sure that you recognise the risks involved.
Advisers looking for high grade predominantly major bank linked credit exposures, without the conversion risks associated with hybrids, should consider Russell Corporate Bond ETF ("RCB"). This offering targets higher rated quality exposures and liquidity by selecting (a) corporate issuances that are rated A or higher by S&P, (b) have a term to maturity of no longer than four years and (c) equally weighting the portfolio with up to 10 issues, predominantly major bank issuers, with at least two issues per issuer. While the yield on RCB is lower than hybrids investors in RCB are able to access a higher yield available from predominantly senior bank debt at the shorter end of the yield curve without assuming the conversion risk associated with hybrids. Such an ETF may act as an alternative or compliment to bank hybrids within an investor’s portfolio.