Download June 2008 Performance Review – Listed Hybrid Sector

June 2008 Performance Review – Listed Hybrid Sector
Manager
performance
The Elstree Enhanced Income Fund’s Net Asset Value (NAV) decreased over the
month of June from a price of 0.8814 per unit to 0.8439. This represents a return over
the month of -4.25%. This compares with the All Ordinaries Accumulation Index and
the UBS All Maturities Bond Index which returned -7.3% and +0.3% respectively. The
Fund’s over the year net return (after fees and before adjusting for the value of
franking credits) fell to -13.54% from -9.60% previously. In gross terms the return fell
to -12.0% from -8.15% previously. The underperformance this month was
attributable to broad based tax loss selling and more specifically to falls in the prices
of securities the Fund has exposure to including the Futuris, Paperlinx, BBI
Infrastructure and Allco Alleasing hybrids.
Market
inefficiencies
Although it is having short term negative impact on hybrid sector returns, there are
some intriguing imperfections in credit markets, particularly in the hybrid sector
where the marginal investor/divestor is charging an extremely high risk premium,
resulting in extremely attractive yields. Evidence this month includes;
 Issuer buybacks; 2 issuers announced buybacks this month. A Timbercorp
satellite and the ALE pub group announced buybacks of their listed hybrids.
The logic is simple. The market is pricing their hybrids at around 17% and
13% respectively and they can borrow from banks at (we estimate) 9% - 10%
(which is lower than the coupon rate they are paying on the hybrid). So they
buy their stock back at a discount and book a profit and lower funding costs.
This phenomenon shouldn’t last for long, as supply of hybrids will reduce
to meet demand and prices will rise.
 Brookfield Asset Management, Multiplex’s parent, issued a preference share
in Canada at 5% coupon, which is around 1.25% over swap. The parent also
finalised a $450m credit facility. We think these events are inconsistent with
the 33% yield on the MXUPA security which is assuming both that
Brookfield will not refinance the MXUPA security, and that the yield will be
5% higher than the 3.9% margin reset coupon. Not bad for a quasi
investment grade security.
 DUET, an infrastructure vehicle which owns regulated gas and electricity
utilities has a hybrid which was due to be reset in September. We suspect
that if they came to the hybrid market it would be refinanced at around 5%
over bank bill, despite the investment grade credit rating. They actually
refinanced with bank debt at 1.8%. Even more intriguing was the secondary
market price action. Our analysis indicated that under whatever scenario
DUET chose at the reset date (i.e. refinance, redeem, convert to equity) we
could ensure that we got the $105 cash redemption value. We don’t think we
are that much cleverer than the rest of the market, so other people should
have been able to undertake the same analysis. Up until DUET made the
announcement, the security was trading around $3 less than the theoretical
value. The moment the announcement was made, it reverted to fair value.
There is yet another example of the mistrust present in the market.
___________________________________________________________________________________________________________
Elstree Investment Management Limited (ABN: 20 079 036 810)
Level 15, 333 Collins Street Melbourne VIC 3000
Telephone: 61 3 8689 1348
Email: [email protected]
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
There are 2 securities that will go through a similar reset process in
September. Both issuers, Gunns and Australand have a number of options
as to what they can do at maturity (i.e.) convert to equity, redeem or reset at
much higher coupons (circa bank bill +5% margins). Currently the market is
pricing them at around $90 meaning that they expect a meaningful chance of
default in 3 months or that if 2 issuers reset with a coupon margin of 5%, the
subsequent securities will trade at $90 implying yields in excess of 16%. We
rate this alternative as the least likely as both issuers can finance from banks
at much lower margins, although we suspect they will do a combination of
equity and debt to refinance the hybrid. We have never seen this level of
uncertainty before particularly as these issuers have to announce their
intentions in July/August.
Bank Capital:
more hybrids
The anticipated rush of bank hybrid issues continued this month. Macquarie issued
$600m at 3.5% margin and Westpac announced a $950m issue (increased from an
initial $600m) at a margin of $2.4%. We understand NAB will approach the market
later in July and ANZ have a $1b hybrid that matures in September that they need to
refinance. Supply has finally had an effect on major bank hybrid margins in the
secondary market with margins increasing by around 0.5%. Margins on regional
bank hybrids increased even further. At these levels, regional banks will issue equity
rather than hybrids.
And looking
down the
barrel of more
equity
The driver for this issuance is two fold: lots of asset growth results in the need for
capital and drying up of overseas markets means issuance has to take place in
domestic capital markets. The table below shows levels of total asset and ordinary
equity for the last 2 reporting periods of the major banks
Total Assets
Total Equity
March 08 ($b)
2,035
101
March 07 ($b)
1,598
91
Change (%)
27%
12%
Asset growth
+ equity price
falls = lots of
cheap hybrids
Normally asset growth of 27% would result in the need for substantial additional
capital, but banks have been saved by the adoption of the Basle 2 capital standards
which require less capital for housing assets and cash. Australian banks hold lots of
housing assets and the credit crisis has meant higher holdings of cash. Australian
banks don’t like issuing equity as it dilutes EPS growth (WBC has fewer shares on
issue now than it did in 1993) and the fall in share prices has meant that issuing
hybrids at yields of around 1.5% higher than last year’s margins is more palatable
than issuing equity at 40% below last years prices. Australian banks have the
capacity to issue up to $2b each of hybrids, so if you don’t like the yields on offer
now, there is a good chance they will be around for a while yet, particularly if banks
don’t issue equity.
Not enough
equity?
We’re intrigued by APRA’s position on bank capital. Previously they had announced
that although Basle 2 would result in banks having to hold less capital, they didn’t
___________________________________________________________________________________________________________
Elstree Investment Management Limited (ABN: 20 079 036 810)
Level 15, 333 Collins Street Melbourne VIC 3000
Telephone: 61 3 8689 1348
Email: [email protected]
2
want a reduction in the amount of capital in the system; less capital means more
systemic risk. With the current situation and last year’s asset growth, the banking
system was either over capitalised last year or it’s undercapitalised this year by
around 10% or $10b. We suspect there are 1:10 rights issues in the pipeline.
Infrastructure
valuations
Last month we said we would have a look at infrastructure valuations, particularly
the Pennsylvania Turnpike transaction.
Penn
Turnpike:
how did they
come up with
that price?
To recap: the Penn Turnpike transaction was the sale of a major road system to a
consortium of a Spanish constructor/infrastructure group and a Citibank
infrastructure fund for $12.8b. Macquarie bid $8.1b and TCL bid $12.1b. The major
variables were; what would be the drop off in traffic volumes when the toll increased
by 25% in 2009 and what would be the cost of capital/debt? We understand that
Albertis/Citi expected a much lower traffic volume drop off than did Macquarie, but
the major driver of infrastructure valuations is the discount rate. Everybody is using
the same debt cost which implies that the equity risk premium is the value driver.
The table below shows the implied equity risk premium for the various bid levels.
Albertis Citi (assuming no fall in patronage
from 2009 price increase)
Albertis/Citi (assuming 5% fall in patronage
from 2009 price increase)
Macquarie (assuming 5% fall in patronage
from 2009 price increase)
Equity risk
premium
4%
Value ($b)
$12.8
4%
$11.6
6.4%
$8.1
What price?
We pretended we were investment bankers and worked out what the investment
IRR would be if the structure was appropriately geared. We couldn’t work out an
effective investment structure for the Albertis/Citi price (probably why we’re not
investment bankers) unless debt costs dropped dramatically in the next year or 2 and
they were able to refinance the structure from the proposed 55% debt levels to
something higher. Otherwise the price paid seems to be stupid. The price
Albertis/Citi paid only made sense using last year’s debt costs and availability and
last years equity risk premium. Using this year’s debt cost and availability, 60%
gearing we could generate an 11% return from Macquarie bid levels, which would
seem to be the minimum level new investors may want from a geared infrastructure
investment.
Does this
mean all
infrastructure
investments
are 30%
overpriced ?
It depends on how long you assume the increased costs of equity and debt continue.
We think that debt costs on infrastructure were impossibly low last year and that
equity risk premiums were too low, so that would mean there is some permanent
diminution in value. The extent to which current credit market events are
overreacting will determine how much of the 30% will be recovered. Investors in
equity markets have voted with their feet and prices have fallen substantially.
___________________________________________________________________________________________________________
Elstree Investment Management Limited (ABN: 20 079 036 810)
Level 15, 333 Collins Street Melbourne VIC 3000
Telephone: 61 3 8689 1348
Email: [email protected]
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Outlook
Despite a bad month, we feel more comfortable with the market. Hybrid securities
that displayed a high correlation to equity price falls early this year were less highly
correlated this sell off and we expect that the ones that were more highly correlated
this month will follow the same path in the future. We are very underweight the
bank hybrid sector which has performed poorly and will continue to deteriorate in
the short term and we’re overweight the non banks which will either get more
expensive or be refinanced (using banks) as they approach maturity. While we
recognise that we haven’t been predicting secondary market sentiment particularly
well we have been predicting issuer outcomes with a much higher degree of
accuracy. We expect that the gaping inefficiencies that are prevalent in the market
will be resolved shortly and as these inefficiencies are unwound we will generate
some material outperformance. That said, we expect a continuation of choppy but
generally favourable pattern of returns that we have seen over the past 3 months.
Performance Table
Elstree Enhanced Income Fund
UBS Warburg Bank Bill Index
1 month
3 months
12 months
-4.25%
0.65%
2.8%
1.9%
-13.54%
7.3%
Since Inception %
Per Annum
6.4%#
6.1%
*Returns are net of fees and do not include the benefit of franking credits. Past performance is not necessarily a guide to future performance.
# Gross return
Disclaimer
The information and opinions contained in this report have been obtained from sources of Elstree Investment Management Limited (ABN
20 079 036 810) believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate
or complete and it should not be relied upon as such. Information and opinions contained in the report are published for the assistance of
recipients, but are not relied upon as authoritative and may be subject to change without notice. Except to the extent that liability cannot
be excluded, Elstree Investment Management Limited does not accept liability for any direct or consequential loss arising from any use of
material contained in this report.
___________________________________________________________________________________________________________ 4
Elstree Investment Management Limited (ABN: 20 079 036 810)
Level 15, 333 Collins Street Melbourne VIC 3000
Telephone: 61 3 8689 1348
Email: [email protected]
___________________________________________________________________________________________________________
Elstree Investment Management Limited (ABN: 20 079 036 810)
Level 15, 333 Collins Street Melbourne VIC 3000
Telephone: 61 3 8689 1348
Email: [email protected]
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