Income Portfolio Blog

While we’ve seen a recent recovery in the stock market that has lifted a number of different sectors, one area of the market that remains largely unloved is the listed debt sector (or the hybrid market as it is usually referred). Determining whether there is any fundamentally appropriate reason for the under performance is key, and whether this is likely to be an ongoing trend or whether we are looking at an opportunity for capital growth as well as the usual income the sector is known for.

Admittedly when we’re talking about the recent under performance of the sector we haven’t taken note of the fact that the out performance was significant as the ASX 200 plummeted from its highs in 2015 near 6,000 to below 4,800 points at one stage. Certainly when looking at the hybrids issued by the big banks – widely seen as the lowest risk hybrids because of the likelihood that their debt will ultimately be guaranteed by the government – the volatility and falls haven’t compared to their ordinary share counterparts. But compared to historic movements in hybrids we’ve seen surprising volatility and interestingly the falls haven’t coincided with rising interest rates which is often a catalyst for weakness.

One likely cause of the weakness has been the bashing the sector has received from the press, primarily in response to the disastrous listing of the Commonwealth Bank PERLS VII (trading under the code ‘CBAPD’). The CBAPDs have performed atrociously for holders since they listed in late 2014, trading at a discount on day one and having dipped to as low as $85.00 earlier this year which is a 15% discount to its face value. The reasons for this were primarily because the margin above the cash rate paid by CBA was a meagre 2.8% and also because the sheer size of the issue ($3bn) meant that the whole sector was sold off to fund it. So even though the reasons for the poor performance of CBAPD were specific to itself, that listing marked the turn in sentiment for the sector and the beginning of the campaign by the press to discredit the sector.

What has been lost in the bashing by the press has been the fact that every investment has a price, and the sector has been marked down significantly. So while the CBAPDs might have been overpriced given the risks versus return profile, that may not be the case at $85.00. The hybrid sector only really came into favour because of the hunt for yield by a market facing all-time lows in the cash rate. Australians holding cash are now facing real returns below zero (which is the interest rate minus inflation) and with interest rates still at risk of falling further the investment case for yield is still very relevant.

But while interest rates plumb new lows, demand for hybrids remains weak. Since the GFC, we haven’t seen such a wide margin between the cash rate and the yield on offer in the hybrid sector. The yields offered on the big banks is one thing, and given their typically short-dated redemption dates the yields haven’t moved too far. It is on the second tier issuers where you can really see a difference in what the market is prepared to pay.

Take the Multiplex Hybrids (MXUPA) as an example. These are perpetual notes which means that they won’t trade closer to their face value as the redemption approaches as there is no redemption (unless Multiplex decided to redeem them). The MXUPAs currently trade at $71.00 which puts them on a yield of 8.5%. As can be seen from the chart to the right, this is the biggest margin between the cash rate and the running yield for years. Meanwhile the listed property trust sector continues to reach multi-year highs which demonstrates this is less a concern about Multiplex’s financial health and more a general malaise in the hybrid space.

Considering our view that interest rates remain likely to stay low for some time longer, we feel that this short-term negativity in the hybrid space will only be temporary and therefore we are now seeing fantastic opportunities for both excellent yields as well as capital upside once the sector returns to favour (and yields are marked down). Our Income Portfolio has a balance of low-risk and high-risk names which combined offer a balanced mix of yield and capital upside.