Key questions an investor needs to ask before investing in hybrids

Hybrids are perpetual which means that they do not have any fixed maturity date and could remain on issue if they are not redeemed, converted or transferred to a third party (also known as being ‘resold’). In this case you would not be issued any ordinary shares or receive your investment back.

• You can sell your investment on the ASX if it is listed (although the market price may be less than the face value you paid for the Hybrid).
• The bank may redeem or transfer the Hybrid for cash, or provide you with ordinary shares in the bank or its listed holding company if it converts the Hybrid, at its discretion on a scheduled date or following certain tax or regulatory events, subject to conditions (including APRA’s prior approval); or
• You may receive ordinary shares in the bank or its listed holding company if the Hybrid automatically converts on or following a scheduled date (subject to conditions).
• You may receive ordinary shares in the bank if the Hybrid converts in other circumstances set out in the terms. Some Hybrids provide for this to occur following a change of control of the bank.

If the Hybrids are converted into ordinary shares of the bank, the value of the shares you receive may be less than the face value. There is also a risk in certain cases that the Hybrids are written-off and all your rights are terminated, if ordinary shares cannot be issued when required.

Hybrids will convert into a variable number of ordinary shares:

• on or following a scheduled date, usually between 7 to 10 years after the Hybrid is issued;
• at the bank’s option in a scheduled date, usually between 5 to 8 years after the Hybrid is issued;
• following certain change of control events;
• at the bank’s discretion following certain tax or regulatory changes; or
• automatically following a trigger event which occurs when the bank is in financial difficulty.

Conversion will be subject to certain complex conditions (except where conversion occurs following a trigger event).

Holders of Hybrids cannot request conversion.

Hybrids may contain a requirement to convert into ordinary shares of the bank on or following a scheduled date (usually between 7 to 10 years after the Hybrid is issued), subject to a number of complex conditions. If the conditions are not satisfied then conversion may not occur and the Hybrids may remain on issue indefinitely.

If a Hybrid is converted, you will receive a variable number of ordinary shares in the bank or its listed holding company. Ordinary shares are generally more liquid than an investment in the Hybrid and may be able to be sold on the ASX.

The bank typically has a right to redeem the Hybrid or convert the Hybrid into ordinary shares in the bank or its listed holding company earlier than any mandatory conversion date on or following a specified date at its option, which may be earlier than the date you expect. This date is typically between 5 and 8 years after the Hybrid is issued.

The bank typically also has a right to redeem or convert a Hybrid at any time following changes to tax laws or regulatory requirements which make the Hybrid more expensive for the bank to leave the Hybrid on issue or reduce the capital benefit of the Hybrid to the bank.

If the bank exercises this right, your investment may be repaid earlier than expected at a time when rates or similar instruments are lower and so your return may be lower.

Yes, the bank’s right is subject to a number of conditions, including obtaining prior written approval from  APRA. You should not expect that APRA will give its approval for the bank to exercise its right and the bank may not exercise its right.

Whether a bank would exercise its right to redeem or convert a Hybrid early is subject to a number of other factors, including the bank’s regulatory capital requirements and financial condition at that time, the market conditions prevailing at the time and the cost to the bank of replacing the Hybrid.

Hybrids are typically listed on the ASX and you may be able to sell them on the ASX at the prevailing market price in the same way as ordinary shares to realise your investment.

However, there is no guarantee that there will be enough buyers on the ASX to enable you to sell your Hybrid. Trading in Hybrids is typically less liquid than trading in ordinary shares.

The market price also may be less than the purchase price you paid for the Hybrid due to prevailing market rates (especially for fixed rate securities), the market for similar securities, general economic conditions and the financial condition of the bank.

This may result in you selling at a loss or not being able to sell at all.

The market price of Hybrids may be volatile and may fluctuate markedly over time.

Like ordinary shares, the market price may fall to below the price you originally paid for a Hybrid, especially if the bank fails to pay distributions or there is a decline in its financial position. Changes in the bank’s share price and credit quality and other interest rates may also be reflected in the price of a Hybrid on the ASX and this may result in you selling at a loss.

If a Hybrid is listed on the ASX, you can find the market price of the Hybrid on the ASX website.

Example: How Many Ordinary Shares Will I Receive on Mandatory Conversion?

This example of how many ordinary shares in the bank or its listed holding company are typically issued on mandatory conversion of a Hybrid is for illustrative purposes only and the actual number of ordinary shares issued may be higher or lower than this example.

In this summary, we have used the following assumptions:

• the average price for the bank’s ordinary shares over the 20 days on which those shares traded immediately prior to the issue of the Hybrid is $25. This is known as the “Issue Date VWAP”.
• the face value of the Hybrid is $100.
• a discount of 1%. The discount generally reflects the estimated costs of selling the shares on the ASX.

Step 1. Calculate the number of shares to be issued on conversion

The conversion mechanics require the average share price (or VWAP) at conversion to be determined, which for a mandatory conversion, is over the 20 days on which shares are traded immediately prior to conversion.

For this example, a VWAP of $25 will be used. Any conversion discount is applied to the VWAP.

The number of ordinary shares to be issued is then calculated by dividing the face value of the Hybrid by the discounted VWAP.

Step 2. Determine the impact of the conversion conditions

There are often a number of complex conversion conditions to mandatory conversion set out in the terms of a Hybrid. Typically they require that at, or just prior to, conversion:

• the ordinary shares of the bank must be listed; and
• the price of the bank’s ordinary shares have not fallen significantly (generally, the ordinary share price must be greater than approximately 50% of the Issue Date VWAP at the relevant time).

If any of these conditions are not satisfied then conversion is deferred until the next distribution payment date on which the conditions are satisfied.

These conditions effectively ensure that a maximum conversion number does not apply on mandatory conversion to limit the number of shares which can be issued. This protects the holder from suffering loss following conversion on the scheduled conversion date.

In this example, where the Issue Date VWAP was $25 and the price of the bank’s ordinary shares was $12.50 or less at the time of the proposed conversion, the conversion conditions would operate to prevent conversion from occurring.

The conversion conditions are complex.

The conditions are typically imposed to ensure you never receive ordinary shares on mandatory conversion either worth less than the  face value  of the Hybrid or that cannot be traded on the ASX. The conversion conditions are complex.

Hybrids are required to automatically convert into ordinary shares of the bank if the bank is in financial difficulty. Specifically, if:

• APRA determines that the bank will become non-viable. This is known as a “non-viability trigger event“; or
• the bank’s common equity capital ratio  significantly declines to or below 5.125%. This is known as a “common equity capital trigger event“.

Conversion of this kind is not subject to any conditions being satisfied.

Hybrids are “loss absorbing” because investors are at the risk of suffering loss if the bank is in financial difficulties and a  non-viability trigger event  or common equity capital trigger event occurs. This is typically effected through Hybrids automatically converting into ordinary shares in the bank or its listed holding company where the bank share price has fallen significantly or being  written-off , in full or in part. This  loss absorption  borne by Hybrid investors protects depositors in the bank.

APRA has not provided any guidance on when it will consider a bank to be non-viable. However, it is likely that APRA will consider a bank to be non-viable where, for example, the bank is suffering from significant financial stress, is insolvent or cannot raise money in the public or private market or would require an injection of capital from the government.

The ratio is a measure of a bank’s financial strength. It measures the amount of common equity capital that it holds. Each Australian bank is required by APRA to hold an amount of  common equity capital  in excess of a minimum ratio.

A bank’s “ common equity capital ” includes it’s ordinary shares, certain reserves and retained earnings. This is also referred to as “common equity Tier 1 capital”.

A higher capital ratio indicates a stronger capital position which is important to ensure that a bank is able to satisfy its obligations under the Hybrid and absorb losses.

If a bank’s ratio is too low then this may indicate that the bank is suffering financial difficulty and the bank may not be able to pay distributions or redeem the Hybrid.

The bank’s financial disclosures will usually contain details of the ratio as at the end of the relevant period covered by those disclosures.

On conversion, you will receive a variable number of ordinary shares in the bank or its listed holding company. This is calculated in the same way as for mandatory conversion and the number of shares will be calculated by taking the face value of the Hybrid and dividing it by the prevailing share price at the time of conversion after applying a discount of approximately 1%. The discount is applied to generally provide for the costs of selling the ordinary shares on market, should you choose to do so.

However, the number of ordinary shares an investor will receive is subject to a cap if the bank’s or its listed holding company's share price has fallen to less than 20% of its level when the Hybrid was issued. As the bank will be in financial difficulty at this point, it is likely that the bank’s or holding company's share price will have fallen to a price significantly below that 20% level.

This means that you may receive ordinary shares in the bank or its listed holding company worth significantly less than the face value of the Hybrid and may suffer loss as a consequence. You will not be entitled to any compensation in this case.

Example: How many ordinary shares will I receive on conversion following a trigger event?

This example of how many ordinary shares in the bank or its listed holding company are typically issued on conversion of a Hybrid following a trigger event is for illustrative purposes only and the actual number of ordinary shares issued may be higher or lower than this example.

In this summary, we have used the following assumptions:

• the average price for the bank’s ordinary shares over the 20 days on which those shares traded immediately prior to the issue of the Hybrid is $25. This is known as the “Issue Date VWAP”.
• the face value of the Hybrid is $100.
• a discount of 1%. The discount generally reflects the estimated costs of selling the shares on the ASX.

Step 1. Calculate the number of shares to be issued on conversion

The conversion mechanics require the average share price (or VWAP) at conversion to be determined, which for conversion following a trigger event where the bank is in financial difficulty, is over the 5 days on which shares are traded immediately prior to conversion.

For this example, a VWAPs of $4 will be used. Any conversion discount is applied to the VWAP.

The number of ordinary shares to be issued is calculated by dividing the face value of the Hybrid by the discounted VWAP.

Step 2. Calculate the Maximum Conversion Number

A maximum conversion number applies where Hybrids are required to be converted following a trigger event.

The maximum conversion number is calculated by applying the average share price at issue of the Hybrid (the Issue Date VWAP, which in this example is assumed to be $25) by a multiple specified in the terms of the Hybrid. The multiple for conversion following a trigger event where the bank is in financial difficulty is determined for regulatory and ratings requirements as 0.2.

The face value of the Hybrid is then divided by the product of the Issue Date VWAP and the relevant multiple to determine the maximum number of shares which can be issued.

This maximum conversion number is fixed at issue of the Hybrid and (except in a number of limited circumstances) will not change over the life of the Hybrid.

Step 3. Determine the impact of the maximum conversion number on the number of shares issued

The table below sets out the impact of the maximum conversion number in this example.

There are no conditions to conversion in these scenarios and so conversion will automatically occur if the bank is non-viable or the bank’s common equity capital ratio equals or is less than 5.125%.

Where the number of shares to be issued is limited to the maximum conversion number (for example where the average share price at conversion is $4 and so has fallen by more than 80% from the date of issue of the Hybrid), the Hybrid will convert into the maximum conversion number of shares, in this case 20 shares. Assuming the prevailing share price remains the same, investors would suffer significant loss as the shares they receive would be worth significantly less than the face value of the Hybrid.

If for any reason conversion does not occur following a trigger event and the shares are not issued to you within 5 business days of the trigger event occurring, then the Hybrid will be written-off. This means all your rights in relation to a Hybrid are terminated, you will not be entitled to any compensation or unpaid distributions and you will suffer loss as a consequence.