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.)