How hybrids would fare under dividend franking shift
Up to 20 per cent of investors holding additional Tier 1 (AT1) securities would be negatively affected by Labor's proposal to end cash refunds of excess imputation credits, says Morningstar's John Likos.
As many as 20 per cent of investors holding additional Tier 1 (AT1) securities would be negatively affected by the Australian Labor Party's proposal to end cash refunds of excess imputation credits, says Morningstar's John Likos.
The proposed change would bring an abrupt end to a key advantage of the hybrid securities, according to Likos, Morningstar's director of equity and credit research, Australia. He addressed the topic in a recent report, which is available to Premium subscribers.
"Labor's proposed policy burden falls largely on the end investor, not the issuer.
"Some investors stand to lose a significant proportion of their total return on their hybrid investments by having the cash rebate removed," he says.
Likos also believes the change could create broader market changes by causing issuers to increase pricing and adjust the size of issuances.
"Unlike hybrids, the impact on equity investments is mitigated by capital upside potential as well as a higher dividend yield to start with.
"Nevertheless, while many investors have much to lose from this proposal, most hybrid investors will continue to benefit from fully franked dividends, up to the point where their franked returns offset their tax liabilities," Likos says.
Not killed, just limited
He reminds investors that dividend imputation would still remain--a point that has been confused or under-emphasised in some commentary.
"Franked dividends will continue to have a franking credit attached to them, but the refund provided by the Australian Taxation Office for any excess credits over tax payable will be scrapped.
"It does not mean franking will come to an end. The ability to use franking credits to offset tax liabilities will be retained."
Despite the "furious public backlash" which saw Opposition Leader Bill Shorten soften the original proposition, Likos emphasises that only a small proportion of the total group of investors that receive cash refunds or buy hybrids would be affected.
Even so, he says his watchlist of AT1 securities "has largely been a sea of red" since the proposal was floated.
This has been priced into the securities, creating attractive buying opportunities--which has seen Morningstar recently increase its ratings of several notes, including the ANZ Capital Notes 4 (ANZPG).
Not a fait accompli
"Of course, beyond Labor winning the next election, there remain further hurdles for this policy to be enacted. In particular, the proposed legislation must get through both houses of parliament.
"Given the last Federal election and the way that played out with regards to the high number of independent candidates winning seats, this is no certainty," Likos says.
However, he suggests there is a good chance such a policy would be passed, a scenario that would affect the medium-term dynamics of the AT1 market.
"We believe the recent AT1 sell-off has been overdone, presenting attractive opportunities for medium- to high-risk investors with the tolerance to invest in AT1s."
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Glenn Freeman is a senior editor at Morningstar.
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