You take all the risk
Banks and insurers issue hybrids to raise money that can count as regulatory capital under the prudential standards that apply to banks and insurers.
All new hybrids issued by banks and insurers are designed to be loss absorbing, which means you, not the bank, are at risk of suffering a loss. This protects the bank’s depositors, at the expense of hybrid investors.
Warning
If the bank experiences financial difficulty, bank hybrids can be converted into bank shares, which may be worth less than your initial investment, or even written off completely, meaning you could lose all of your capital.
Capital notes and convertible preference shares
Capital notes and convertible preference shares are very similar. You should receive regular interest payments, sometimes called distributions or dividends. On a fixed date, around 8-10 years in the future, you should receive ordinary shares in the bank that issued the hybrid, although they may decide to repay you in cash.
These hybrids can behave very differently depending on a range of factors that are outside your control. The terms often contain a complex series of events, tests, conditions and approvals that even experienced investors can find difficult to understand.
You may not get payments
Interest may not always be paid on capital notes and convertible preference shares and missed payments will not accumulate. Although if payments are not made, the bank is prevented from paying dividends on its ordinary shares. Your investment may convert into ordinary shares instead of being repaid in cash, and this may occur years before or after the scheduled date.
Prospectus terms explained
Here are the meanings of common terms used in capital note and convertible preference share prospectuses.
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Discretionary non-cumulative distributions – Interest payments are not guaranteed, they are paid at the discretion of the issuer. Missed payments do not accumulate.
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Unsecured and not guaranteed – The issuer does not guarantee your investment will be repaid, and unlike savings accounts or term deposits with a bank, hybrids are not covered by the Government guarantee. Your investment is not secured by a mortgage or security over any asset.
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Subordinated – If the issuer becomes insolvent, investors in capital notes and convertible preference shares are the second last group to be repaid if there is any money left. You will rank behind all other creditors but ahead of ordinary shareholders.
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Scheduled conversion or mandatory conversion – The hybrid will convert into ordinary shares in the issuer on a fixed date, usually 8-10 years after the hybrid is issued, provided that the issuer’s ordinary share price has not fallen by more than 50% in that time.
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Optional redemption, resale or transfer – The issuer can repay your investment (or in some cases, convert it to ordinary shares) early if they meet certain conditions and receive regulatory approvals. This can occur on one or more fixed dates, typically beginning 6 years after the hybrid is issued, or any time there is a change to laws or regulatory requirements affecting the hybrid.
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Perpetual – Despite a number of terms specifying when your investment can be repaid or converted into shares, capital notes and convertible preference shares have no fixed maturity, which means your investment may never be repaid.
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Loss absorption – If the issuer experiences financial difficulty, they may be required to convert your investment into ordinary shares or write it off completely, meaning you could lose some or all of your investment. This is often described as a ‘loss absorption event’, a ‘capital trigger event’ or a ‘non-viability trigger event’.
Subordinated notes
Subordinated notes issued by banks and insurers have very different features and risks to those issued by other companies. They are more like capital notes or convertible preference shares but with a fixed maturity date, an expectation that interest will be paid, and no scheduled conversion into shares. Interest payments and repayment of your capital have fewer conditions.
Prospectus terms explained
Here are the meanings of common terms used in subordinated note prospectuses.
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Unsecured and not guaranteed – The issuer does not guarantee your investment will be repaid, and unlike savings accounts or term deposits with a bank, hybrids are not covered by the Government guarantee. Your investment is not secured by a mortgage or security over any asset.
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Subordinated – If the issuer becomes insolvent, you will rank behind senior debt holders and other creditors for a return of any capital, but rank ahead of capital note and convertible preference shareholders.
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Interest – This is payable at regular intervals and is not discretionary.
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Redemption – The issuer must repay your investment on maturity, often 10 years after the hybrid is issued.
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Early redemption – The issuer can repay your investment early, but only if they receive regulatory approval. This can occur on one or more fixed dates, typically beginning 5 years after the hybrid is issued, or at any time if there is a change to laws or regulatory requirements that affect the hybrid.
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Loss absorption – If the issuer experiences financial difficulty, they may be required to convert your investment into ordinary shares, or write it off completely, meaning you could lose some or all of your investment.
Case study: Daniel weighs up the risk and return of capital notes
Daniel has $20,000 in a term deposit with BIG Bank. When it matures, he is offered a rate of 4.5% if he reinvests his money for a further 12 months.
He has seen a story on a news website about a new capital note being offered by BIG Bank, which promises to pay 6%, so he downloads a copy of the prospectus.
Reading through the prospectus, Daniel is surprised to learn that if BIG Bank experiences a ‘loss absorption event’, his capital notes will automatically convert into ordinary shares in BIG Bank. These shares may also be worth much less than his initial investment because a complex formula limits the number of shares he can receive.
While Daniel doesn’t think BIG Bank is going to fall over any time soon, he’s not prepared to take the chance and invest in their capital notes. His term deposit is government guaranteed, and he doesn’t think it is worth all that complexity and risk for an extra 1.5%.
Capital notes, convertible preference shares and subordinated notes are complex investments. While they are issued by banks and insurers, they are very different to a savings account or term deposit.
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Source : ASICs Moneysmart March 2018
Reproduced with the permission of ASIC’s MoneySmart Team. This article was originally published at https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes/bank-hybrid-securities
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