Bank hybrids at current prices are for fools only

There has been a mad rush in recent times to buy bank hybrids which have pushed their prices up to imprudent levels. The money is of course coming from retail investors fleeing the insanely low interest rates on bank deposits (as well as from some very lazy and not too bright institutional investors, there’s no shortage of them).

So, why do I say this? Because of the following points:

1.    Many hybrids trade at premiums to their share conversion value which ensures that anyone buying at these premiums and holding to conversion will realise a capital loss with 100 percent certainty;

2.    Taking the above point into consideration, when working out the yield to conversion, most of these hybrids will provide a return only marginally higher than current two year term deposit rates (but with equity like risk);

3.    Hybrids rank so far down the debt structure that they are (for practical purposes), almost indistinguishable from equity; and

4.    Hybrids are generally non-cumulative, so if the bank misses a payment, it does not have to make it up.

That’s why anybody buying these securities at current prices is a fool. And note the word current. Hybrids themselves can be a good investment, but only at prices much lower than those currently prevailing.

Right now, buying the actual issuing bank’s shares is almost certainly going to be a better deal for investors, as most of these provide a dividend yield of 6 percent or more (with franking credits). 

Yes, the banks are being squeezed on margins by the nutcases at the RBA (i.e. Philip Lowe’s reckless behaviour based on a fantastical employment problem), but you will find that they will pass on far less of future rate cuts (while at the same time continuing to rip money away from depositors and also dreaming up new fees to charge customers – they always win and the Banking Royal Commission has changed nothing).

The duplicitous behaviour of the banks was exemplified by ANZ’s Chief Executive, Shayne Elliott who told the media that ANZ was only passing on 18 basis points of the 25 basis point cut in June in order to protect depositors. A few weeks after this statement, it then proceeded to slyly cut seven, eight, nine, 10 and 11-month term deposits by 25 basis points. It cut the five-month term deposit rate by a whopping 60 basis points and also cut the ANZ Progressive Saver rate by 20 basis points. Absolutely disgraceful. They have learned nothing from the Royal Commission.

But I digress.

I am a keen watcher of the ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve and this has been showing for many months that it was very likely that rate cuts were coming. 

Knowing this, early this year, I was very keen on loading up on selected REITs, as some of them had yields that were very high in comparison to where the RBA cash rate was headed. This has already proven to be a far superior investment to bank hybrids. I also pushed out term deposits that were maturing at that time to two year terms (at rates that are now unavailable).

Apparently the Australian share market is trading on a price-earnings ratio of 15.8 (or an inverted yield of 6.33 percent). Now, in an environment where the cash rate was at (say) four percent, that would be looking pricey, but at a cash rate of 1.0 percent (or less), that is not at all expensive. And this is the mistake being made by many naïve analysts who say the market is expensive - they are looking at historical price-earnings ratios that prevailed when RBA cash rates (and 10 year bond yields) were vastly higher than they are today. It’s an amateurish mistake, but most of these analysts are indeed amateurs.

I’m not advocating that people start allocating significant amounts of their portfolios to the Australian share market, but moderate allocations in a well-diversified portfolio of large caps with solid dividend yields is not a bad thing in this environment. 

(The graphic at the start of this article is from The Guardian.)

The May 2019 RBA Cash Rate decision & the random predictions of economists

The RBA very sensibly chose not to lower the cash rate at their meeting on 7 May 2019. 

Of course it remains to be seen whether they will be conned into making a cut later this year by those who believe they can micro-manage the economy to an absolutely ridiculous degree.

I have been arguing for some time that another rate cut is not required and I won’t repeat those arguments again here, but I thought it would be interesting to take a close look at which economists (at major financial institutions) got the rate call correct and who got it wrong.

The following information (sourced from Bloomberg) shows who passed and who failed:

 

Economist	Firm	Estimate	Pass or Fail?
Shane Oliver	AMP Capital	1.25	Fail
David Plank	ANZ	1.25	Fail
Tony Morriss	BAML	1.5	Pass
Rahul Bajoria	Barclays Bank	1.5	Pass
Marcel Thieliant	Capital Economics	1.25	Fail
Joshua Williamson	Citigroup	1.25	Fail
Michael Blythe	Commonwealth Bank	1.5	Pass
Philip Odonaghoe	Deutsche Bank	1.5	Pass
Paul Bloxham	HSBC Bank Australia	1.5	Pass
Rob Carnell	ING Bank	1.25	Fail
Sally M Auld	JP Morgan	1.25	Fail
Stephen Roberts	Laminar Capital	1.5	Pass
Justin Fabo	Macquarie Group	1.25	Fail
Stephen Koukoulas	Market Economics	1.25	Fail
Chris Read	Morgan Stanley Australia	1.5	Pass
Michael Knox	Morgans	1.25	Fail
Kaixin Owyong	NAB	1.5	Pass
Andrew Ticehurst	Nomura	1.25	Fail
Matthew Peter	QIC	1.25	Fail
Su-Lin Ong	Royal Bank of Canada	1.25	Fail
Klaus Baader	Societe Generale	1.5	Pass
Besa Deda	St George Bank	1.5	Pass
Chidu Narayanan	Standard Chartered Bank	1.5	Pass
Annette Beacher	Toronto Dominion Bank	1.25	Fail
Bill Evans	Westpac	1.5	Pass

As you can see, when the decision that the RBA has to make becomes difficult, the economists’ predictions become sheer pot luck. Of the 25 economists listed above, 13, or just over half, got the call wrong. You could have flipped a coin and obtained a similar outcome.

As Pepperstone’s head of research, Chris Weston stated in an AFR article on 8 May 2019: 

As it turned out, the central bank not only held rates steady, but those who had been betting on a rate cut were not even supplied with more tangible evidence the RBA was considering an imminent move. As a result, traders positioned for a cut would have been "absolutely destroyed".

Any of the institutions shown above that actually traded on the advice of the economists (who were wrong) would certainly have lost money.

A special mention to Shane Oliver at AMP, Sally Auld at JP Morgan and Su-Lin Ong at RBC – you were all completely wrong but were all over the media talking your own book. Well, hopefully it’s a case of “once bitten, twice shy”.

David Plank at ANZ must also be feeling like a real loser - his counterparts at the other three big banks got the call correct.

As the very astute Christopher Joye of Coolabah Capital stated in the AFR of 3 May 2019:

Earlier in the week I revealed that APRA and the RBA were sensibly considering cutting the minimum interest rate banks apply when working out how much they will lend to a borrower from 7.25 per cent currently to 6.25 per cent, which would instantly increase borrowing capacity and purchasing power by about 5 per cent.

This is actually a vastly better solution than lowering the cash rate further. The RBA should also revise down its antiquated inflation targets and hold fire for real emergencies, like a recession. It also needs to completely ignore the opinions of celebrity economists, and at least this time, it has.

What happens if the RBA lowers interest rates?

The ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve is forecasting two cash rate decreases of 0.25 percent in 2019.

The call for rate cuts seems to have picked up velocity after “celebrity” economist Shane Oliver (the one with the terrible dyed blonde hair) started making noises about the need for rate cuts. As the sage of Omaha once said, “economic forecasters exist to make astrologers look good”.

Christopher Joye, portfolio manager with Coolabah Capital Investments, has been one of the very few commentators to have been highly critical of the Reserve Bank of Australia’s insane policies. A quote from Coolabah’s web site:

Needless to say, the RBA is doing its best to once again irresponsibly inflate the hazards to which prudent investors are subject. It is quite staggering that with a 5.5 per cent jobless rate, which is a sliver above full-employment, and headline inflation within the RBA’s target band, that the central bank nonetheless deems it appropriate to impose a negative real cash rate on savers.

Other more sensible central banks around the world understand that if you keep rates too-low-for-too-long you inevitably blow asset price bubbles, an observation that has been completely lost on a myopic and immensely arrogant Martin Place, which is preternaturally incapable of admitting it is wrong.

Oh no, the rate cuts in 2016 had nothing to do with the “surprising” and striking re-acceleration in national house price growth back to double-digit rates in the months that followed. No, that was all about housing supply. Seriously Phil, bite the bullet brother.

I couldn’t agree more.

The RBA is now so addicted to the drug of inflated house prices that it is seriously contemplating rate cuts to an already artificially low rate when there is no recession and employment is as good as it has been in this country for at least 50 years! And this is all because people might feel a little poorer because their houses in Sydney and Melbourne have decreased in value by perhaps 10 percent or so, after a run up of 60-70 percent in recent years! It’s patently absurd.

Then the RBA Governor, Philip Lowe (a real life version of Nassim Taleb’s “Dr. John” character), had the audacity to call on employers to lift wages. They need to lift wages because many people in Sydney and Melbourne cannot afford to buy a house and are being hit with sky high energy prices – both of which are a direct result of government policy! 

The problem is, employers are not responsible for the breathtaking incompetence of government and they are already struggling under the burden of Australia’s already high average weekly ordinary time earnings (AWOTE), so dream on Phil – it’s not going to happen. (And if the jingoistic Bill Shorten wants to lift the minimum wage, go ahead, business will simply employ less people.)

At this point, the attempt to micro-manage the economy through the blunt instrument of interest rates is neither necessary nor ultimately effective. And let’s please remember that the majority of Australians own their own home or rent, those with a mortgage are in a minority (but are always pandered to by self-serving politicians and their factotum public servants).

The RBA has already lost significant control over interest rates. Approximately half of Australian bank funding is sourced from offshore (largely the US) and is thereby beholden to the rates that fund providers in those offshore debt markets require. A relative of mine who is a banker, told me on the weekend that if the RBA does cut rates, the banks are unlikely to pass on any more than 10-15 basis points (if they can even manage that). 

The cheapest funding source for Australian banks is domestic household deposits. These deposits finance approximately one third of the banks’ total funding needs. Most of this money comes from self-funded retirees and high net worth individuals (not always mutually exclusive groups). As pointed out by Coolabah Capital Investments, after tax, the return on these deposits is negative, i.e. below inflation.

Now, if the RBA cuts rates and banks choose to reduce rates on household deposits (i.e. term deposits) at the same time that a federal Labor government is in power (and has taken away the refunds on excess franking credits*), bank depositors will be forced to move part of this money out of the banks and into alternative (higher yielding) investments. Banks will then replace deposit funding with more costly funding sources such as hybrids and offshore funding, which in turn could result in independent bank rate rises. The exact opposite of what the nutcases at the RBA are trying to achieve.

This of course will all take time to play out, but it will happen if the RBA and the Labor party are stupid enough to do what we are supposing they will do.

Another casualty will be the Australian dollar. If the RBA actually makes two 25 basis point cuts, there is no way the Australian dollar will stay in the 70s against the US dollar. In recent times, backing the US dollar against the Australian dollar has been like shooting fish in a barrel.

Australia is a large net importer of manufactured goods and petroleum and this will result in price inflation on these goods, once again hitting the average person in the hip pocket.

With friends like the RBA and the Australian Labor Party, who needs enemies?

* Does anyone actually think that a Labor government will responsibly utilise the billions they think they are going to save from the abolition of refunding excess franking credits? And to all those younger people with self-funded retiree parents or grandparents who are thinking that all of this won’t affect them – like a thief in the night, the Labor Party is about to steal a good part of your inheritance.