Wealth manager Challenger has cancelled plans to launch new a hybrid security issue, which it was to have used to redeem its current issue of Challenger Capital Notes. It has pushed out repurchase of the outstanding hybrids by up to two years.
Challenger’s move is the latest in a series of setbacks for the hybrid market this year, highlighting the risks involved in an asset that many investors see as an alternative to term deposits.
The $345 million of notes have a call date of 25 May this year and a mandatory conversion date of 25 May 2022.
Challenger has received approval from the Australian Prudential Regulation Authority to repurchase the notes on any quarterly distribution payment date up to the mandatory conversion date.
A spokesperson for Challenger said it was yet to be determined whether the notes would be redeemed all in one go or in a series of transactions.
In the meantime, note holders will continue to receive quarterly distribution payments. The notes will continue to be traded on the ASX, where they are currently selling for around $87 – 13 per cent below their face value.
In a letter to note holders, Challenger said: “While there is no guarantee that on a future distribution payment data APRA will grant its approval for Challenger to repurchase the notes, Challenger will endeavour to repurchase them when market conditions allow.”
Challenger said it remains “strongly capitalised”. Its life company has a capital ratio 1.55 times the prescribed capital amount. Challenger Ltd has cash of $400 million drawn under a group banking facility and it can inject $250 million of this into Challenger Life as common equity tier 1 capital.
Earlier this month Macquarie Bank and NAB both withdrew hybrid issues, citing market volatility and its likely impact on the price of the notes once they listed.
Macquarie withdrew its $500 million offer of Macquarie Capital Notes 2, which it had launched on February 11, saying it made the decision “in light of significantly changed market conditions in recent weeks.”
NAB withdrew a $1.9 billion offer of NAB Capital Notes 4, which it had launched on February 25.
Both banks refund all the money raised. Both banks also repaid investors in old capital note issues that had reached their call dates.
Most of the capital notes listed on the ASX are now trading below their $100 face value – some of them well below.
Hybrid securities have been popular with retail investors in recent years because they are issued by banks, in the main, and offer relatively high yields.
NAB was offering a margin of 2.95 per cent above the bank bill rate on its capital notes. Macquarie was offering a margin of 2.9 per cent over bills on its issue.
Hybrids combine features of debt and equity securities and they involve higher risk than traditional fixed income investments.
The banking regulator APRA imposes conditions on the issue of hybrids if banks want to count them as part of their regulatory capital.
Distributions on capital note are discretionary and they typically have a perpetual term rather than a fixed maturity.
They can be converted into equity by the issuer or the regulator if certain trigger events occur. These events include a fall in a bank’s level of regulatory capital or where a bank encounters severe financial difficulty. These conditions are sometimes referred to as “bail-in” provisions.
When such events occur, hybrid holders are likely to receive shares that are worth significantly less than the face value of the hybrids they have bought.
With the markets in turmoil, investors have turned their attention to the equity characteristics of hybrids.
Back in 2016 Kevin Davis, professor of finance at the University of Melbourne, delivered a paper at an Actuaries Institute conference in which he said: “We face problems with these instruments. We haven’t got a clue.”
Davis, who was a member of the 2014 Financial System Inquiry, said bail-in conversion may or may not expose security holders to a loss on the face value of their hybrids, depending on the issuer’s stock price at the time, and conversion may be partial or full.
“Appropriate pricing requires the ability to model the risks of such securities, using some form of asset pricing model. However, bail-in securities include imprecise specifications of the trigger event and imprecise specification of the actual conversion arrangement. This makes modelling difficult,” Davis said.
“Bail-in securities are more appropriately characterised as involving uncertainty rather than risk that can be modelled.
“Bail-in is a new type of risk and it would be expected to attract a risk premium, compensating for the risk that the securities could be converted to equities or written off. Because of the opacity of the risk involved, there may be little conversion risk sensitivity in the pricing.”
The Australian Securities and Investments Commission has been warning for years that investors do not understand the risks they take on when they invest in hybrids. ASIC has said it is concerned that investors do not understand that maturity dates on hybrids can be deferred, sometimes in perpetuity, that dividend or interest payments can be cancelled and that the market value of the securities can fall.
In a 2017 interview, former ASIC chair Greg Medcraft said hybrids were a “ridiculous” product for retail investors. Medcraft said hybrids had been banned in the UK and other markets.
The same year, Standard & Poor’s downgraded big bank hybrids, dropping them below investment grade. And in June Europe’s Single Resolution Board cancelled all the shares and hybrids of Spain’s Banco Popular in response to the bank’s failure.
Hybrid securities, which can be included as additional tier one or tier two capital, had to offer non-cumulative distributions, which means that if the issuer misses a distribution payment it does not carry over to the next distribution period.