Labor’s Franking Policy Could Put Retirees Invested In Bank Hybrids At Risk

The growing alarm over an ALP plan to cut franking credit refunds for retirees is heavily centred on the impact the policy will have on shares — global broker Citi recently listed it as the No 1 issue for local investment markets if we have a change of government.

But a large number of retiree investors also invest in hybrids in the search for fully franked yield — the most popular hybrids are from the big banks. There is also a hybrid ETF from Betashares.

Over more than a decade bank hybrids they have been aggressively sold to investors and in particular by the private banks.

A hybrid security combines elements of both debt and equity, in that it promises to pay a rate of return which can be either fixed or floating for a defined period of time. This is similar to the workings of a traditional debt security. However, the equity component is such that a hybrid can provide a higher rate of return because there are greater risks associated with the equity component.

The other key risks in hybrids include the element of doubt in the certainty of meeting the defined period of time, the ability to convert the security into equity or to be redeemed or terminated at a time beneficial to the holder, and the fact that as a security a hybrid can rank below other creditors in the event of insolvency. Nevertheless, they remain popular.

Hybrid securities have the following key features:

● Cash running yield: the annual distribution is usually derived by a margin over BBSW (bank bill swap rate or reference rate) and is then divided by the cash value of the security.

● Gross running yield: the cash running rate plus the attached franking credits.

Retiree investors have been keen on hybrids because the franked dividends result in a refund cheque every year — the average refund is more than $6000. The refund is due because of the tax-free status of most retirees.

ANZ offers a useful example of how this works. In the example they use a margin for the distribution of 4.7 per cent over the BBSW (now 1.8 per cent) equalling an unfranked distribution of 6.5 per cent. The franking component is 30 per cent (or the company tax rate) as they are fully franked. In this instance the unfranked distribution of 6.5 per cent is multiplied 0.7 (1 minus the corporate tax rate) which gives a cash distribution rate of 4.55 per cent.

Therefore, an investor in such an example receives a 4.55 per cent cash distribution and a franking credit of 1.95 per cent. These franking credits have been used to offset tax liabilities.

Where an investor is in pension mode, and therefore below the transfer balance cap of $1.6million, that investor has been able to claim a tax refund for the franking credits.

Where an investor is in accumulation phase or has an accumulation account (in other words they have not retired yet), and face earnings in their fund taxed at 15 per cent, the franking credits have been used to offset any liability and any excess has been claimed as a refund.

It is these franking credits and the inability to use excess franking credits that I believe change the game negatively for hybrids.

Hybrids are also renowned for being illiquid, in that they are easy to purchase and often quite difficult to sell, especially if we are talking about a significant quantity or in circumstances where there are many sellers. This problem is most common for non-bank hybrids.

Just because a security is listed does not guarantee liquidity. To sell, you need buyers on the other side and the lack of depth in the market of hybrids has made these securities well known for their liquidity issues.

Coming back to the risk scenario of a potential change of government: there is no doubt in my mind that the proposed reforms on the abolition of refunds on excess franking credits by the ALP, were they to become law, will discriminate against both retirees and those with SMSFs.

If you are currently one of these investors and have exposure to hybrids through your SMSF, whether it is in pension mode or in the accumulation phase, it is strongly recommended you take the time to make yourself aware of the potential changes. Don’t be cautious. Take advice to ensure you are not one of the pack that will head straight for an exit at the same time when change puts the spotlight on the impacts of holding a potentially illiquid security.

One other thing: Liberal MP Tim Wilson announced this week that the House of Representatives economics committee will examine the potential impact on retirees of the ALP plan. The inquiry will examine who receives franking credits and how they may be affected. The results will make for some very interesting reading.


By Will Hamilton (the managing partner of Hamilton Wealth Management)

The Australian

22 September 2018

#SelfManagedSuperFund #SMSF #Superannuation #Fund #Labor #FrankingCredits #Retirement

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