Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 245

Impact on hybrids of Labor’s franking policy

A Labor Party win at the next Federal election may change the dividend imputation system with potentially significant impacts on self-funded retirees. Fears that the abolition of excess franking credit refunds will cause a substantial disruption to the hybrid market are unlikely. However, as with any change there is always potential for winners and losers, and with that comes opportunity.

A long way to go in its current form

There are a number of events required prior to this policy becoming legislated, including:

  • The Labor Party would have to win government at the next Federal election
  • The policy would have to withstand changes to water down its impact
  • The legislation would need to pass in both the House of Representatives and the Senate.

There are doubts about all three to varying degrees and the probability of all three occurring appears relatively low. The second and third points are somewhat related. The proposal as currently structured is unlikely to receive support in the Senate. Changes may be required to ensure low-income earners are protected, such as introducing a cap on claims. If the policy is watered down, the proposal may continue to struggle unless the Labor Party has a majority in the Senate.

Likely to lead to a buying opportunity

Even if legislation is enacted as initially communicated, it is unlikely to be a death knell for the hybrid market. While SMSFs and self-funded retirees account for a substantial part of the hybrid market, they aren’t the only investors who can utilise the franking credits. In the retail space, for example, SMSFs in accumulation phase and self-funded retirees with other taxable income will continue to gain the full benefits of fully franked hybrids. The market also includes institutional buyers.

That’s not to say there won’t be some dislocation. There is likely to be a sell-off of hybrids as investors who can’t utilise the franking credits transfer them to those who can. Also, given the pool of potential fully franked hybrid investors will diminish, there may be an increase in margins attached to new hybrids. For those who can use the franking credits, that is good news. The increase in margins, however, is likely to be moderate creating a relatively minor impediment for hybrid issuers rather than a permanent roadblock.

The proposed changes have already impacted the hybrid market, with bank and insurance securities experiencing a sell-off and adding to the widening trend that commenced in February. The following chart from Bell Potter shows that trading margins on the most common major bank hybrids (the black line) have increased from around +275bps to +350bps since early February 2018, a material move. We believe there may be some further weakness in the near term but ultimately this will be seen as a buying opportunity.

Click to enlarge. Source: Bell Potter Fixed Interest Weekly 16 March 2018

Notwithstanding that the impact on the more recent Basel III hybrids is likely to be less than the market is anticipating, our preferred hybrids remain the pre-GFC/legacy perpetual income style securities such as those listed on the ASX under codes NABHA (National Australia Bank) and MBLHB (Macquarie Bank). We believe that there is a high probability that there will be a buy-back and/or redemption of these securities in the next few years with either option resulting is substantial capital gains from current levels.

More detail on NABHA

The National Income Securities (ASX:NABHA) are a legacy Tier 1 hybrid that was issued in 1999. We believe NAB will look to replace the NABHAs with a Basel III compliant hybrid (i.e. Additional Tier 1 security such as the NABPDs) when the NABHA’s become inefficient capital between 2020 and 2022 and that investors will be able to exit at $100.

Based on a current price of $78.55 (at the time of writing), this equates to the following yields to call depending on the timing of the potential exit:

Our base case is that this will likely happen on the first coupon payment date in 2021 (i.e. 15 February 2021 – highlighted in blue) which would equate to yield to call of 12.5% (or a trading margin of +10.3% over swap). Further, NABHAs are set to benefit from any recycling out of traditional hybrids that may be impacted by the ALP’s proposed franking changes given that NABHAs do not have any franking credits attached but rather pay the entire coupon in cash.

We believe that although the documented maturity is ‘perpetual’, NAB will retire the NABHAs before 2022 for three key reasons:

  • Capital/regulatory treatment – these legacy securities will no longer count towards capital ratios from 1 January 2022
  • Replacement cost – NAB can replace the NABHAs with cheaper and/or more capital effective securities
  • Precedent - the recent buybacks of the NAB USD Libor+15bps (i.e. very cheap) legacy Upper Tier 2 capital security.

Of course, much can happen between now and 2022 and investors must make their own enquiries and judgement, and the Labor Party policy has added an element of uncertainty to the outlook for hybrids.

 

Brad Newcombe is a High Yield Analyst, Fixed Income at Mint Partners Australia. Individuals should make investment decisions based on a comprehensive understanding of their own financial position and in consultation with their own financial advisors.

 

RELATED ARTICLES

What might the Tax White Paper say on imputation and CGT?

The potential and perils of increasing franking credits

The best income-generating assets for your portfolio

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

  • ASFA
  • 13 November 2024
Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.