Hybrids – Yields set to fall
The recent APRA paper proposing changes to a bank’s capital structure will reduce the requirement of banks to issue hybrids (Capital Notes or AT1 capital). Whilst there is much water to flow under the bridge on how this plays out, the current crop of listed hybrids will be well sought after, driving hybrid prices higher and in turn yields down. This has already commenced. The APRA paper will take submissions and have an ultimate ruling but expect little or no issuance in the interim.
Last week the major bank average hybrid yield hit a post-GFC low as shown in the chart below. As a result, the total yield (which is the sum of the bank bill rate and the trading margin) is much lower than what was available a few months ago and heading under 6% (including franking). If this continues rightly investors will question whether getting say only a margin of 1.60% or so is enough for the risk. Mind you the APRA ruling almost guarantees that the hybrid is repaid at the first optional cash repayment date, although this was the market’s assumption anyway. Hybrid yields may trade at the same rate as bank sub notes. We have seen this before explained by idiosyncratic factors in either category, such as lack of issuance. Further, hybrid margins and yields always incorporate the franking value, which can vary from bank to bank. For example, CBA, NAB and Westpac are 100% franked whereas ANZ is 65% and Macquarie 40%. This just means the cash amount varies but the total (cash and franking value) is the total yield (bills + margins). The point is that the market quotes total hybrid yield which always contains franking value. A sub note paying the same total yield is all cash – more valuable as no waiting for credit refunding via tax returns.
So what for investors to do if yields continue to fall? An alternative is a well-diversified fund that is returning the same or higher yield in cash. Funds that invest further up the capital structure offer a far superior risk/return profile to a hybrid portfolio. These find also invest in hybrids but are highly tactical. Further for large investment such funds offer superior liquidity in a crisis.
Interest Rates
Finally, the US Fed meeting arrived and didn’t disappoint with a large 0.50% cut, the market balanced between 0.25 and 0.50%. The market is now pricing in a cut of 0.25% in both November and December. The Fed is comfortable that inflation is moving towards 2% however looks like it’s rushing despite the economy being in reasonable shape. The cut was largely priced in, 2-year treasury yields flat for the week at 3.585% and 10 years up by 0.08% to 3.74%. Hence the yield curve has steepened.
Australian rates rose for the week, our yield curve moving higher relative to the US. August’s Labour Force Survey released last week showed the Australian labour market is strong and hence any thought of a rate cut now pushed well into 2025. The RBA meets this week, and the monthly (August) CPI is also released on Friday. Government energy rebates may result in the CPI easing however the RBA is cognisant of this temporary effect. 2-year Comm. Gov. bonds closed at 3.576% and 10 years at 3.93%.
Major Credit Markets
Investment grade (IG) margins were initially stronger after the 0.50% rate cut which is good for balance sheets. However, at week-end IG margins had widened after several Fed members expressed less commitment to the easing pace being priced by the market after the initial 0.50%.
Calmer global markets especially after the Fed rate cut saw Australian IG margin fall to recent lows. Of the 25 corporates in the iTraxx index, the largest movers tighter in recent trading have been Macquarie Bank, NBN Co, Telstra, Scentre Group and Qantas. Issuance was strong: Origin launched and priced a new A$500m 7-year Senior deal at a margin of 165bps. Suncorp Bank also launched and priced an AUD1.4bln dual tranche 3 & 5-year FRN at BBSW+74 and BBSW+92 respectively.
High Yield Markets
US high yield (HY) was stronger with margins falling after the 0.50% Fed cut was deemed good for HY balance sheets in reducing costs. The sector was also helped by large fund inflows and the strong equity markets.
Collectively, hybrid margins tracked sideways for the week the major bank average hybrid margin marginally changed at 1.90%. However, this masked underlying changes. ANZ hybrids were generally stronger, CBA mixed but NAB and Westpac overall weaker. In the non-majors a similar story, overall mixed but Suncorp weaker.
The new Macquarie Bank hybrid listed, rising on the APRA news buying strength to close at $102.14, a margin of 2.33%, well in from the 2.65% IPO pricing. Volume was solid at $24.6m traded for the week.
