Posted April 25, 2012 Twitter: @PaperlinXsuX
Why are fixed income professional investors avoiding listed hybrids? Food for serious thought for Oz FI investors and debt issuers.
It is hoped that the directors of PaperlinX read this posting very carefully.
This was published in Australia today by FIIG Securities Limited, a fixed income specialist http://www.fiig.com.au. It is published in its entirety. The original by Emma Jenkin is here.
With over A$6.5bn of the new-style equity hybrids issued and listed on the ASX in the last six months, the Australian market is providing issuers with access to large amounts of capital. For the banks and insurers this likely qualifies as regulatory capital (Tier 1 and Tier 2) under the new international banking regulations, Basel III. For corporate issuers, they benefit by receiving equity credit from the ratings agencies. In this article, we will examine who is buying the ASX listed securities and how the pricing compares to similar issues, both Tier 1 and Tier 2, in the over-the-counter (OTC) market.
To start, let’s have a look at how hybrids are priced and who has been buying them in the primary market over time.
In the primary market, the amount of compensation investors require to purchase new securities from an issuer is measured by the credit spread or yield a security offers. The credit spread is determined by a process of price discovery and this is achieved via a book-build that is run by the lead manager - usually an investment bank. In this process, different investors will put a series of buy orders (bids) into the book at different levels across the book-build range (for example, the recent Colonial Subordinated Notes issue had a book-build range of 325bps to 375bps).
As result of hybrids having equity and debt features they attract different investor types including: institutional fixed income funds, institutional equity funds and retail investors. Institutional investors evaluate the risk associated with each issue and place their bids into the book across the range and the investment bank running the book-build process will set the price (usually in consultation with the issuer) based on the aggregated volumes bid at each level.
The most recent hybrid issues have seen a decrease in the participation of larger institutional investors in the primary process. This trend is demonstrated in Figure 1, which depicts the proportion of the primary issue that is purchased by the Top 20 investors for different issues over time. This measure is imperfect as it often includes the aggregate private client holdings of investment banks and brokers as a single holder, however, it clearly shows a fall from up to 50% to around 20% as the market has moved from more debt-like hybrids to equity-like hybrids.
An examination of the names on the Top 20 list reinforces this as the large fixed income investors who were present in early hybrids are no longer on the register and this is coupled with the number of investors purchasing over $10m of securities halving to only 5 in recent issues.
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Why is this important?
The absence of institutional investors, particularly fixed income investors, has the potential to change the pricing in the book build process. These investors are sensitive to both the level of protection offered by the securities and the credit spread they receive for the risk they are taking.
The likely reason for the absence of fixed income investors is a dislike of the equity-like structure and/or the level of the credit spread they receive for taking this risk. In other words, they see better value elsewhere in the market.
Who is buying the equity-like hybrids issued today? The answer is retail investors who are chasing yield. Retail investors are typically less sensitive to the book-build range and often their brokers will aggregate client bids and place them into the book across the range or at clearing.
This can result in the setting of the price at the lower end of the range (and this has been the experience with the new issues in 2012 with all but one pricing at the lower end of the book-build range). At FIIG, we see the listed hybrid market pricing being much tighter than comparable securities in the OTC market.
So, what price does the institutional market require for Tier 1 and Tier 2 issues and how does this compare to listed hybrids? First off, let’s have a look at the big four banks latest equity-like listed hybrids versus some of their OTC Tier 1 securities. As Figure 2 below shows, institutional investors are requiring between 250 and 450bps additional yield to hold OTC Tier 1 securities.
On top of this the OTC Tier 1 securities are structurally superior to the listed hybrids as they include step-ups giving investors greater comfort that the securities will be called. The story for corporate issues is similar (albeit there are very few securities to compare) with the structurally superior OTC securities (again they have step ups at the first call date) trading 350 to 450bps over the listed comparable securities (Origin Energy is a good example where the margin for the Euro sub-debt is 7.27%, yet the ASX listed hybrid which is higher risk is only 3.58%).
ASX listed versus OTC hybrids
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^ $A margin as at 23 April 2012, all prices are a guide only and subject to market availability
* Retail clients may purchase this security all other securities are for wholesale clients only
Many of the above OTC securities are non-A$, so for investors who prefer A$ securities that offer an attractive yield we would point you towards Swiss Re, AXA, NAB CAPs and Rabobank (see our recent article on AXA versus Swiss Re). Also, for retail investors you will note that the only retail security in the above list is the National Wealth (FRN) ’16.
Please see our latest article on how to qualify as a wholesale client in order to expand your investible universe.
All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.
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