In early 2018, the Australian Labor party announced proposed changes to franking credits in a document titled “A fairer tax system – ending cash refunds for excess imputation”. Investors unable to claim franking credits will be affected by these changes. This will have a clear negative impact on investors with large share portfolios that pay franked dividends. But those who have in the past diversified their investment portfolio through exposure to bank hybrids (which offers both a fixed income style income stream, as well as franking credit upside) will not be immunised from that impact either.
There has been a steady stream of hybrid issuance by the major banks in 2018 and NAB has recently announced a new ASX-listed perpetual (i.e. with no fixed repayment date) hybrid. The NAB Capital Notes 3 are rated sub investment grade and are expected to raise a minimum of $750m in new Tier 1 capital for the bank. The margin on this hybrid has been set at 4.00% over 3mBBSW. This looks attractive at first but the attractiveness is quickly eroded when we take out the benefit of full franking.
Investors unable to claim franking credits will receive a lower cash coupon, while still taking on the higher risk associated with hybrids. Assuming a 3mBBSW rate of 2.00%, these investors will actually receive a cash coupon of 4.20%, rather than 6.00%. In our opinion, this is not a prudent risk reward trade off. This is only marginally above the coupon an investor would receive on a Tier 2 instrument which, unlike a hybrid, has a fixed date for capital repayment.
Investment options
We believe the best way for investors affected by this change to maintain a regular coupon is to invest funds in corporate bonds, either in higher ranking bank subordinated Tier 2 securities or in a portfolio made up of various DirectBond investments.
For example, the recently issued AMP Tier 2 bond, with an expected call date in November 2023 and final repayment date in November 2028 pays a fully unfranked cash coupon of 2.75% over 3mBBSW and is rated investment grade, which is multiple notches higher than the NAB hybrid. On an unfranked basis, with an assumed 3mBBSW rate of 2.00%, clients will pick up 55bps in cash coupon if they invest in the AMP Tier 2 bond rather than the NAB hybrid, and substantially improve the credit quality of their investment.
Furthermore, we expect the proposed changes to the four major banks’ capital requirements announced by APRA to result in a higher amount of Tier 2 issuance by these institutions. This increase in supply should therefore result in wider coupon margins, making the Tier 2 securities even more attractive when compared to hybrids.
Rather than investing in one security, diversification of investments is a better way to lower risk while maintaining yield. Our three sample portfolios each have exposure to Tier 2 securities and offer expected yields in the range of 4.20%pa to 6.36%pa.
If you would like any further information or to find out more about investing in fixed income, click here or call us on 1800 01 01 81.
