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Key questions an investor needs to ask before investing in hybrids

When considering whether to invest in Hybrids, you should make sure that you understand their key features and risks. The answers to these frequently asked questions contain further details on the typical key features of Hybrids.

Distributions

Hybrids typically pay regular distributions in the nature of interest or dividends on fixed payment dates (which are usually quarterly or semi-annual). The distributions are calculated on a pre-determined basis and are based on the face value of the Hybrid.

The distribution rate is typically a “floating rate” which means that it is calculated as a fixed margin (set just before issue of the Hybrid) over a reference rate, usually the Australian bank bill swap rate (known as “BBSW”). The reference rate will be reset on each fixed distribution date and so may vary throughout the life of a Hybrid but the margin will not change. As a result, the distribution rate can change in response to changes in market conditions.

The method of calculating distributions is different to how a bank determines dividends on ordinary shares, which is typically based on its profits.

Example of how distributions are calculated

This example of how distributions are typically calculated on a Hybrid is for illustrative purposes only and actual distributions paid on any Hybrid may be higher or lower than this example.

In this example, we have used the following assumptions:

• a margin of 4.7% per annum. Typically the margin will be set just before the date the Hybrid is issued and is fixed for the life of the Hybrid.
• a bank bill swap rate (or BBSW) of 1.8% per annum. Typically this rate will be set on the date the Hybrid is issued and then reset on each distribution payment date (which is typically quarterly or half-yearly).
• Distributions are scheduled to be paid quarterly (or approximately every 91 days).
• the face value of the Hybrid is \$100.
• the corporate tax rate for the bank is 30% and the Hybrids are fully franked.

Step 1. Determine the unfranked distribution rate

The unfranked distribution rate for each period between payment dates will need to be calculated. The unfranked distribution rate is calculated as a percentage on an annual basis by adding the margin and the bank bill swap rate:

Margin 4.70%
Plus the bank bill swap rate (BBSW) + 1.80%
Equals the unfranked distribution rate = 6.50%

This rate does not take into account the level of franking on the distributions.

Step 2. Determine the impact of franking

Where a Hybrid is franked, investors will receive a combination of cash distributions and franking credits. Franking credits represent your share of the tax already paid by the bank in relation to the amounts it is distributing to investors. The current corporate tax rate is 30%.

The unfranked distribution rate is reduced to take into account the value of the franking credits the bank attaches to the distribution. This then produces the distribution rate which is used to determine the amount of the cash distribution that you will receive. So, if the unfranked distribution rate is 6.5%, the distribution rate after taking into account the franking credits is 4.55%.

Unfranked distribution rate 6.50%
Multiplied by (1 – the 30% corporate tax rate) to take into account the value of the franking credits × 0.7
Equals the distribution rate which is used to determine the cash distribution = 4.55%

Step 3. Calculate the amount of the cash distribution that you will receive?

To determine the amount of the cash distribution per Hybrid that you will receive on a payment date, the distribution rate is multiplied by the face value of the Hybrid. As this is an annual rate, this needs to be adjusted to calculate the rate for the number of days in the distribution period.

Franked distribution rate

4.55%

Multiplied by the face value of the Hybrid × \$100
Multiplied by the number of days in the relevant distribution period (which in this example is quarterly) × 91
Divided by the number of days in a year (which is typically fixed in the terms as 365) ÷ 365
Equals the fully franked cash distribution payable on the distribution payment date = \$1.1344

Step 4. Calculate the amount of the franking credits that you will receive?

The amount of franking credits that are applied to the quarterly distribution is calculated as follows:

Cash distribution \$1.1518
Multiplied by the corporate tax rate (currently 30%) × 0.3
Divided by (1 minus the 30% corporate tax rate) to take into account the value of the franking credits ÷ 0.7
Equals the franking credits attached to the distribution payment date. = \$0.4862

In this example the aggregate of the cash distribution paid and franking credits in percentage terms would equal the unfranked distribution rate of 6.5%. This is merely illustrative as it assumes that you can utilise the full value the franking credits and it does not take into account that the potential value of any franking credits does not accrue at the same time as the receipt of the cash amount.

Step 5. Claiming back your franking credits?

Your ability to use franking credits, either as an offset to a tax liability or by claiming a tax refund, will depend on a number of factors, including your individual tax position. As the franking credits are currently calculated on a corporate tax rate of 30%:

• if your tax rate is lower, then you may receive a tax refund; and
• if your tax rate is higher, you may receive a tax offset,

based on of the difference between your personal tax rate and the corporate rate.

In this example, we have used tax rates of 45% (which is the highest marginal personal rate) and 15% (for superannuation funds) to show the effect of tax rates higher and lower than the current corporate tax rate.

15% tax rate 45% tax rate
The total taxable distribution on the Hybrid \$1.1344 \$1.1344
Multiplied by the personal tax rate × 15% × 45%
Equals the tax the holder is required to pay on the total distribution = \$0.1702 = \$0.5105
Less the franking credit – \$0.4862 – \$0.4862
Equals the tax refund due or additional tax payable = a tax refund of \$0.3160 = an additional tax payment of \$0.0243

This example excludes the impact of any Medicare or budget repair levies.

The example is merely illustrative and is subject to a number of factors, including your individual tax position. It also assumes you can utilise the full value of the franking credits and it does not take into account that the potential value of any franking credits does not accrue at the same time as the receipt of the cash amount.

For more information on the Australian tax consequences for potential investors in a Hybrid, you should read the tax disclosure in the relevant Prospectus and seek your own tax advice.

Yes, Hybrids are usually franked. Accordingly, you will usually receive the distribution as a combination of cash distributions and franking credits. If a distribution is not fully franked, an additional cash payment is made to compensate for the unfranked component. The cash amount of a distribution may also change if the corporate tax rate changes, for example the cash amount will tend to increase if the corporate tax rate falls.

Your ability to use franking credits, either as an offset to a tax liability or by claiming a tax refund, will depend on your individual tax position. The potential value of any franking credit does not accrue at the same time as the receipt of any cash distribution and will depend on your personal tax position.

Example: Calculation of Hybrid Distributions

This example of how distributions are typically calculated on a Hybrid is for illustrative purposes only and actual distributions paid on any Hybrid may be higher or lower than this example.

In this example, we have used the following assumptions:

• a margin of 4.7% per annum. Typically the margin will be set just before the date the Hybrid is issued and is fixed for the life of the Hybrid.
• a bank bill swap rate (or BBSW) of 1.8% per annum. Typically this rate will be set on the date the Hybrid is issued and then reset on each distribution payment date (which is typically quarterly or half-yearly).
• Distributions are scheduled to be paid quarterly (or approximately every 91 days).
• the face value of the Hybrid is \$100.
• the corporate tax rate for the bank is 30% and the Hybrids are fully franked.

Step 1. Determine the unfranked distribution rate

The unfranked distribution rate for each period between payment dates will need to be calculated. The unfranked distribution rate is calculated as a percentage on an annual basis by adding the margin and the bank bill swap rate:

Margin 4.70%
Plus the bank bill swap rate (BBSW) + 1.80%
Equals the unfranked distribution rate = 6.50%

This rate does not take into account the level of franking on the distributions.

Step 2. Determine the impact of franking

Where a Hybrid is franked, investors will receive a combination of cash distributions and franking credits. Franking credits represent your share of the tax already paid by the bank in relation to the amounts it is distributing to investors. The current corporate tax rate is 30%.

The unfranked distribution rate is reduced to take into account the value of the franking credits the bank attaches to the distribution. This then produces the distribution rate which is used to determine the amount of the cash distribution that you will receive. So, if the unfranked distribution rate is 6.5%, the distribution rate after taking into account the franking credits is 4.55%.

Unfranked distribution rate 6.50%
Multiplied by (1 – the 30% corporate tax rate) to take into account the value of the franking credits × 0.7
Equals the distribution rate which is used to determine the cash distribution = 4.55%

Step 3. Calculate the amount of the cash distribution that you will receive?

To determine the amount of the cash distribution per Hybrid that you will receive on a payment date, the distribution rate is multiplied by the face value of the Hybrid. As this is an annual rate, this needs to be adjusted to calculate the rate for the number of days in the distribution period.

Franked distribution rate 4.55%
Multiplied by the face value of the Hybrid × \$100
Adjusted to calculate a quarterly amount:
Multiplied by the number of days in the relevant distribution period (which in this example is quarterly) × 91
Divided by the number of days in a year (which is typically fixed in the terms as 365) ÷ 365

Step 4. Calculate the amount of the franking credits that you will receive?

The amount of franking credits that are applied to the quarterly distribution is calculated as follows.

Cash distribution \$1.1518
Multiplied by the corporate tax rate (currently 30%) × 0.3
Divided by (1 minus the 30% corporate tax rate) to take into account the value of the franking credits ÷ 0.7
Equals the franking credits attached to the distribution payment date. = \$0.4862

In this example the aggregate of the cash distribution paid and franking credits in percentage terms would equal the unfranked distribution rate of 6.5%. This is merely illustrative as it assumes that you can utilise the full value the franking credits and it does not take into account that the potential value of any franking credits does not accrue at the same time as the receipt of the cash amount.

Step 5. Claiming back your franking credits?

Your ability to use franking credits, either as an offset to a tax liability or by claiming a tax refund, will depend on a number of factors, including your individual tax position. As the franking credits are currently calculated on a corporate tax rate of 30%:

• if your tax rate is lower, then you may receive a tax refund; and
• if your tax rate is higher, you may receive a tax offset,

based on of the difference between your personal tax rate and the corporate rate.

In this example, we have used tax rates of 45% (which is the highest marginal personal rate) and 15% (for superannuation funds) to show the effect of tax rates higher and lower than the current corporate tax rate.

15% tax rate 45% tax rate
The total taxable distribution on the Hybrid \$1.1344 \$1.1344
Multiplied by the personal tax rate × 15% × 45%
Equals the tax the holder is required to pay on the total distribution = \$0.1702 = \$0.5105
Less the franking credit – \$0.4862 – \$0.4862
Equals the tax refund due or additional tax payable = a tax refund of \$0.3160 = an additional tax payment of \$0.0243

This example excludes the impact of any Medicare or budget repair levies.

The example is merely illustrative and is subject to a number of factors, including your individual tax position. It also assumes you can utilise the full value of the franking credits and it does not take into account that the potential value of any franking credits does not accrue at the same time as the receipt of the cash amount.

For more information on the Australian tax consequences for potential investors in a Hybrid, you should read the tax disclosure in the relevant Prospectus and seek your own tax advice.

No, distributions may not always be paid. The payment of each distribution is subject to the bank’s discretion and is typically subject to further conditions which include:

• the bank not being or becoming insolvent as a result of the payment;
• APRA not objecting to the payment; and
• the bank not breaching APRA’s regulatory capital requirements as a result of the payment.

In particular, the bank may be restricted in paying distributions if the bank’s common equity capital ratio falls below APRA’s specified capital requirements.

Where Can I Find More Information Relevant to Any Decision to Invest in Hybrid Securities? →

As the payment of distributions is discretionary and subject to conditions, investors may never receive a distribution.

No. If a distribution is not paid when scheduled, the missed payment cannot be paid later and you have no right to claim for non-payment or compensation for non-payment. This is referred to as being “non-cumulative”.

To provide some protection to investors, where distributions are not paid, Hybrids typically contain a limited restriction on the bank paying dividends on its ordinary shares or buying back its ordinary shares. The terms of this restriction may vary across Hybrids. This restriction provides some protection because banks will generally seek to avoid being restricted from paying ordinary share dividends.

Maturity

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 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 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 termintated, if ordinary shares cannot be issued when required.

Hybrids will convert into a variable number of ordinary shares in the bank:

• 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 converson 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. 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 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.

No.

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 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.

Face value of the Hybrid \$100
VWAP at conversion \$25.00
Apply the conversion discount (which in this case is 1 – 1%) × 0.99
Equals the adjusted VWAP after applying the conversion discount. = \$24.75
The number of ordinary shares to be issued is calculated by dividing the face value of the Hybrid by the discounted VWAP. = 4.0404

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.

Loss absorption

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 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.

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 of the bank. 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 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 share price will have fallen to a price significantly below that 20% level.

This means that you may receive ordinary shares 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 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.

Face value of the Hybrid \$100
VWAP at conversion \$4.00
Multiply by the conversion discount, which in this example is 1% × 0.99
Equals the adjusted VWAP after applying the conversion discount. = \$3.96
The number of ordinary shares to be issued is calculated by dividing the face value of the Hybrid by the discounted VWAP. = 25.2525

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.

Face value of the Hybrid \$100
Issue Date VWAP \$25
Multiple applied to adjust the Issue Date VWAP × 0.2
= \$5.00
Maximum number of ordinary shares which can be issued = 20 shares

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.

Face value of the Hybrid \$100
VWAP at conversion \$4.00
Number of ordinary shares to be issued applying the conversion mechanics 25.2525
Maximum number of shares which can be issued 20 shares
Effect of the maximum conversion number Holder receives 20 ordinary shares with a value of approximately \$80

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.