Macquarie takes Note

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In today’s bond’s spotlight, we follow up our recent “Mysterious Millionaires Factory” article on Macquarie Group (MQG) to take a look at their floating rate note. The note started life as a Macquarie Bank Limited (MBL) security, hence it’s ASX code. MBL was subsequently incorporated into Macquarie Group. As such, I will refer to MQG throughout this article in lieu of MBL.

The Key Details

Floating interest rate: 90 day BBSW plus 1.7%
Face value $100.00
Market value (as of 14/12/11): $70.00
Current running yield: 8.9%
Payment schedule: Quarterly15th of Jan, Apr, Jul & Oct
Maturity Date: None – perpetual Note
Convertibility: Stapled preference share is not convertible
Funds raised: $400 million
Listing date on ASX: 25 November 1999
ASX code: MBLHB

The 90 day bank bill swap rate (BBSW) is shown below, along with the additional 1.7% margin provided by the note.

The note is perpetual, meaning there is no set redemption date when MQG purchases them notes back. However, MQG may purchase the notes back at any time at the original face value of $100.

The note is also “stapled” (meaning legally joined) to a preference share on a 1:1 ratio – one note joined to one preference share. This share cannot be separated from the note and sold on its own. The preference share provides the note holder no benefit except in the event an interest payment is not made on the note. At this time, the preference share becomes dividend paying. The dividend will be paid semi-annually at a rate equal to the 180 day bank bill swap rate (BBSW) plus 1.7%. During this time the preference share will have limited voting rights.

MQG will not pay interest on the note under the following circumstances:

  • APRA determines that MQG has insufficient Tier 1 capital or an inadequate total capital ratio
  • A liquidation event of MQG
  • MQG is unable to pay its debt within the meaning of the corporations law
  • Any time MQG gives notice in writing to the trustee (who holds the note on behalf of investors) that it’s not going to pay

So basically if MQG’s profits take a nose dive or the regulatory authorities change capital requirements, the note payments may be stopped. The last point is a little concerning as I couldn’t find much more of an explanation in the prospectus. I am assuming it is there to allow MQG to stop payments in a situation that does not fall under the first three scenarios.

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MQG is not under any obligation to repay any missed interest payments, although they reserve the right to provide make-up payments if they are in a position to. Once an interest payment is missed, MQG cannot pay dividends on ordinary ranking shares until at least 4 consecutive interest payments have been made on the notes or a make-up payment has been made. For example, if a Jan 15 payment is not made then dividends on ordinary shares must stop until:

  • MQG provide a make-up payment, or
  • A year’s worth of full note interest payments are made, meaning dividends can start being paid again on April 15 of the following year

Are they good for it? Maybe. I reviewed MQG recently and concluded that the opaqueness behind the details of the business could not satisfy the needs of an risk-aware investor, even though the general aspects of the business are easily understood. However, when investing in debt securities I want to know the following:

  1. What are the total debt obligations of the business and what do they cost?
  2. Can their revenues and/or asset base easily cover interest costs, even during stressed markets?
  3. Have they defaulted on their notes in the past and what is their credit rating?

On the first question, MQG’s borrowings were about $42b in FY11 while interest expenses were $4b. This compares to an NPAT of $0.95B

On the second question, the graph below show’s Macquarie’s earnings before interest and tax (EBIT) to interest expense ratio has been well over 100% for a decade. Even during the GFC, it only dropped to 118% – meaning there was plenty of (pre-tax and interest) earnings to pay interest expenses.

Cash-equivalent assets also sit around $18b, meaning there’s scope for asset sales to cover debt costs.

On the third point, Moody’s downgraded the credit rating of the notes from A3/negative to Baa2/negative in March 2010. In plain English, this means they moved from low to moderate credit risk.

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In short, if everything is fine in the global credit market MQG should be able to pay its bills. But if a credit crunch looms, then things may get dicey for MQG (and our other big banks).

The Return

At the current market price of $69.75, the yield on MBLHB is about 8.9%. This compares quite well to a few example alternate investments, as shown below:

Australian government bond yield, 15 year

4.12%

At-call term deposit (UBank, online base rate)

5.61%

WOW Notes II yield

7.5%

WOW dividend (inc franking credits)

6.7%

However, one needs to remember that the coupon is a floating rate and will change with the 90 day BBSW. The graph of the BBSW shows that it dropped to 3% during the GFC, meaning the coupon on MBLHB dropped to 4.7%. Of course, the flip side is that most people would have considered that pretty good as the financial world faced armegeddon.

To give another perspective, below is a graph showing past MBLHB market prices vs running yields. You can see the impact of the GFC quite clearly, with the yield spiking to almost 16% (nice work to the investors brave enough to snap them up in the low $30 range).

Using a 10 year time frame, an 8% discount rate (to account for the higher credit risk) and assuming resale after 10 years is the same as the purchase price today, the value of the MBLHB note will vary with the coupon rate (90d BBSW plus 1.7%) as shown in the graph below:

 

Summary

On the face of it, MBLHB provides an attractive 8.9% yield – much higher than many other interest securities out there. However, the market has assigned a higher chance of default than when MBLHB traded at – or above – the $100 face value. Given MQG’s liquidity levels and coverage ratio, as well as its continued payment during the depths of the GFC, I think a default is unlikely, if market conditions remain stable. However, in the event of big credit crunch or a significant write down in MQG assets, all bets are off.

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has currently has an interest in one of the businesses mentioned in this article. The article is not to be taken as investment advice and the views expressed are opinions only. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.