Labor's proposed policy to stop paying cash refunds for surplus franking credits to investors with no income will drive up the cost of capital for banks and force investors into high-yield bonds that could significantly reduce the potential tax saving.
That is the view of research analysts at Bell Potter who have told clients that by switching out of bank hybrid securities to a listed high-yield corporate bond fund that does not benefit from franking, investors who will lose thousands of dollars of refunds under the policy can actually maintain the same income.
Bell Potter's hybrid analyst, Damien Williamson, showed clients an example of how investors could potentially maintain the same cash income after tax by shifting half of a $600,000 investment in Westpac's Capital Notes, which pay a margin of 5.25 per cent, into Neuberger Berman's listed global high-yield bond fund, which also pays a margin of 5.25 per cent.
A $600,000 investment in the Westpac hybrid would generate $22,050 in cash and $9450 in franking credits. A self-managed superannuation fund would then pay 15 per cent tax (or $4725), which would offset half the franking credits, resulting in a $4725 surplus rebate and an after-tax income of $26,775.
Under Labor's proposal the rebate would fall away, leaving a lower $22,050 of cash income after tax for the SMSF.
But Bell Potter said that if that investor shifted half its portfolio, or $300,000, into the high-yield bond fund with the same 5.25 per cent yield, the gross income would remain the same at $31,500. This would comprise $11,025 of cash and $4725 in franking credits from the Westpac hybrid, and $15,750 of cash interest from the high-yield fund.
The franking credit entirely would offset the $4725 of tax payable to ensure a zero tax bill.
But the cash income of $26,775, made up of $11,025 from the hybrid and $15,750 from the bond fund, would allow the investor to maintain the same after-tax income than if the policy was not changed.
The analysts therefore argued that as investors shifted into other investments the potential savings for the government may be less than assumed while the reduced attractiveness of hybrids to some investors would increase the margin banks would have to pay for this funding.
"Reallocating investments away from the capital structure of banks to an offshore high-yield income trust is likely to increase bank funding/capital costs," Mr Williamson said.
"This investment strategy also brings into question the quantum of revenue this policy will generate."
Fixed-income research firm BondAdviser estimated the policy change would directly impact more than 1 million individuals, 200,000 SMSFs and more than 200,000 pensioners.
Morningstar's John Likos said in a note at the time that the policy will "strike hardest at the heart" of the bank Tier I hybrid market.
"These hybrid securities are often fully franked, a strong selling point for retail investors, particularly self-managed super funds, or SMSFs."
A change in the policy therefore could reduce the attractiveness of hybrids and at the time the policy was announced in March 2018, margins on hybrid securities were sold off to the point where margins increased by nearly a quarter of a percentage point.
As the opinion polls point towards a Labor victory the change appears more likely.
Labor leader Bill Shorten said the party was "not for turning" on the policy while shadow treasurer Chris Bowen told those destined to lose out because of it "are perfectly entitled to vote against us".
By Jonathan Shapiro
4 February 2019