Australian Convertible Floating Prefs

In a comment on the post about HM Treasury’s musings on mandatorially convertible prefs, Assiduous Reader patc provided an introduction to what seems to be the wonderful world of Australian Hybrids.

Further investigation uncovered a Morningstar / “Huntleys’ Your Money Weekly” analytical report titled ASX Listed Hybrids:

These securities pay a regular distribution or dividend. The calculation for most instruments is similar. Start with the 90 or 180 Day Bank Bill Swap Rate (see graph below), which is the rate at which major financial institutions commonly lend money to each other. This rate often sits a little bit above the Reserve Bank cash rate, so now for instance the 90 day rate is sitting at 3.25%, above the cash rate at 3%. To this you add a margin, which differs from security to security. For instance the ANZ offering, with ASX Code ANZPB, has a margin of 2.5%, CBAPB has a margin of 1.05%, WBCPB has a margin of 3.8%.

The distribution may be franked and the numbers we quote include the franking credit where applicable.

Many bank hybrids have Mandatory Converting Conditions. There are offerings of this variety from Westpac, ANZ and CBA, as well as Macquarie and Suncorp. At the end of the term, around the Mandatory Conversion Date there are tests against the share price of the underlying security. For instance ANZPB is tested against the share price of ANZ. If the volume weighted average share price (VWAP) of the institution is above some threshold just prior to the Mandatory Conversion Date then the issuer must convert the hybrid securities into a variable number of ordinary shares – the value of the shares will be the face value of the hybrid plus a small conversion discount, typically 1%–2.5%. Often there’s a test that the price on the 25th business day before the mandatory conversion date is at least above 55–60% of the issue date VWAP, and then that the VWAP for the 20 business days prior to the conversion date is above 50–52% of the issue date VWAP.

Note that I have no idea what “franking” means!

The potential for a significant market in this asset class in Canada was discussed when the market was just about at its bottom in December 2008 in the post Convertible Preferreds? In Canada?.

Sadly, these preferreds approach mandatory conversion from the wrong direction: mandatory conversion occurs when the price of the common is above some level, rather than below, which – from the point of view of market stability – is undesirable. Ideally, the fixed charges inherent in debt-like instruments will be eliminated when the company’s in trouble – by conversion to common – but in this case the implication is that the fixed charges will remain in such a case, and be eliminated if the company does well (or, at least, treads water).

Note that these Australian instruments bear a distinct resemblance to Canadian OperatingRetractibles, the major differences being:

  • the discount on the common is 1% – 2.5% for these Australian issues, vs. a standard 5% discount for the Canadian issues
  • the existence of a minimum price on the common for the “retraction privilege” to be effective in Australia, vs. no minimum in Canada (presumably, this minimum is the reason the issues may be included in Tier 1 Capital)

3 Responses to “Australian Convertible Floating Prefs”

  1. patc says:

    “Franking” – essentially a tax credit for the company tax paid on dividends (or any post-tax distribution). For ordinary shares an incredibly nice feature which investors rightly adore.

    For Australian hybrids one can have either unfranked distributions out of pre-tax profits or franked distributions out of after tax profits depending on structure. Franking then becomes a bizarre way of sending an investor’s distribution through a round trip via the Tax Office.

    Keep in mind that these securities pay non-cumulative discretionary distributions with a dividend stopper, and while conditions vary a little the regulator has the right to suspend distributions, and there’s automatic triggers on some – e.g. if the regulator measured “Distributable Profits” falls below some measure.

    In simple terms if the bank’s in a real loss-making/treading-water scenario, no distribution and no back-payments. Possibly forever.

    What happens for distressed takeovers is typically a bit woolly however e.g.: “the Board will use all reasonable endeavours to procure that an equivalent takeover offer is made to Preference Share Holders or that they are entitled to participate in the scheme of arrangement or a similar transaction.” (from CBA PERLS V).

    Thanks for the plug by the way!

  2. patc says:

    I should explain franking or “dividend imputation” a bit better,
    because it is one of the truly gorgeous features of the tax system here.

    Suppose I am paid wages of $40,000, and I receive a dividend
    cheque for $700 with a franking credit of $300. My income is $40700.

    To calculate my tax, I “gross up” the income to $41,000, and then
    calculate my tax on the $41,000. Say this is T.

    I then get a credit of $300 on T, so I remit (T – $300) to the tax office.

    The idea is that tax has already been paid on the dividend by the
    company, so this scheme eliminates double taxation, once on the company
    profits and then again on the investor returns.

  3. van coffee says:

    Thanks patc –

    “Franking” is not unique to Australia.

    It is very common, and generally these types of systems are used in “integrated” income tax regimes (like in Canada).

    In Canada we refer to this as the “Dividend Tax Credit” regime, and the dividend tax credit is applied to “eligible dividends” which are essentially dividends paid out of after-tax corporate profits in order to eliminate double-taxation on dividends paid out of “tax-paid” profits. i.e. the fully-flowed-thropugh rate of taxation to the end recipient is the same as if no corporate tac had been paid AND no dividend tax credit (franking credit) was received).

    FYI – the franking regime is of no benefit to a Canadian Investor holding Australian securities. I wish I could get the benefit of all the Franking on my FGL!

    Finally, “Franking” sounds much, much cooler than “Dividend tax credit”


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