Bank hybrids are the type of instrument that combines features of both debt and equity securities. They pay a rate of return until a fixed date, like a bond, and may provide a higher rate of return than regular debt securities. Bank Hybrid Securities consists terms to be converted into ordinary shares or written-off completely in certain circumstances (change of control or bank’s discretion following certain changes in the tax or regulatory rules), including severe financial difficulty. These are generally termed as conversion events. There are two most common types of bank hybrids:
- Tier1 Bank Hybrid: This type of hybrid can exist for indefinite periods and does not have any fixed maturity date. The face value may never be repaid for these types of hybrids. These may also contain call feature which enables the bank to repay the hybrid at an earlier date or call date subject to prior approval from Australian Prudential Regulatory Authority (APRA).
- Tier2 Bank Hybrid: This type of hybrid has a fixed maturity date, and the bank must repay the face value on the maturity date if it is solvent. The interest is determined as the sum of BBSW (Bank Bill Swap Rate) with an added margin. The interest payments vary, and any unpaid interest will be accumulated and payable later as accumulated unless the hybrid is written-off. These interests, however, is denied from franking credits.
There are some conversions of Bank Hybrid which occurs in the following circumstances:
Scheduled Conversion: Tier 1 Bank Hybrids are perpetual, however typically with a set date also called the scheduled or mandatory conversion date (usually can be 7-10 years after they are issued), on which the instruments are scheduled to be converted into ordinary shares. However, the actual conversion depends on several conditions, which needs to be satisfied. If on the scheduled date the, the conditions are not met the conversion will be postponed till the next distribution payment date. The investors will receive bank ordinary shares approximately of $101.01 value for each Tier 1 Bank Hybrid, on the conversion date, as per the conversion condition.
Capital Trigger Event: This takes place when the APRA or a bank determines that the common equity Tier 1 Capital ratio of the bank is either less or equivalent to 5.125%. An event might compel the bank to convert some or all its Tier 1 Bank Hybrids into ordinary shares. In case of a capital trigger event, the conversion of Tier 1 hybrids is not subject to any conditions. In case of an event, the number of Tier 1 Bank Hybrids needs to be converted into ordinary shares is simply the minimum amount required to restore the bank to a common equity Tier 1 ratio above 5.125%.
Non-Viability Trigger Event: A non-viability trigger event generally occurs when APRA informs a bank about the conversion of some or all its bank hybrids to ordinary shares or either the bank needs support from the public sector for infusion of additional capital or to avoid becoming non-viable. Non-viability trigger event is at the discretion of APRA. It considers a bank to be in non-viable status if it is suffering from significant financial distress, insolvent in capability or unable to raise capital through the public or private market. Tier 1 hybrids enjoy a priority over Tier 2 while conversion.
Risks associated with investing in bank hybrids:
- The investors might have to hold the Tier 1 Bank Hybrid for an indefinite period if the conversion conditions are not satisfied and the scheduled conversion of a Tier 1 Bank Hybrid does not materialize.
- The investors cannot request early conversion in case of a callable hybrid; however, they can sell the hybrids in open market at the current market price which might be significantly less than the original face value. The investor might suffer loss for this reduction in value or an illiquid market.
- The investors might suffer a loss in value while conversion due to a significant decline in share prices to the bank’s financial difficulty.
- If the conversion does not materialize, then rights relating to the bank hybrids can be terminated leading to a loss in investment value for the investors. They will not be compensated by any arrear distributions or interests.