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    Shares for Beginners Podcast | Hybrids for beginners

    A huge shout out to Phil Muscatello of the Shares for Beginners podcast for interviewing Brad Dunn, Portfolio Manager of ASX:DHOF. They discuss hybrids for beginners. The first time Phil has covered hybrids on his podcast!

    Brad takes us back to basics, explaining how hybrids work, their role in a portfolio and what he takes into consideration when he constructs his portfolio. Listen to the podcast recording above.

    Additional reading

    Want to read more about hybrids? Here are some links:


    Disclaimer: Please note that these are the views of the writer, Brad Dunn, of eInvest and is not financial advice. To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at

    If you’d like to keep learning further, please feel free to follow any of our socials listed below.


    Podcast Transcript


    Phil Muscatello: So what are hybrids? Today, I’m joined by Brad Dunn to find out what these things called Hybrids are good, I read.


    Brad Dunn: Good to see you, Phil.


    Phil Muscatello: Yeah, great to have you back in the studio.


    Brad Dunn: Lovely to be here.


    Phil Muscatello: Brad Dunn is the senior credit analyst from eInvest’s DHOF ETF. So tell us about hybrids. What are they and what do they mean?


    Brad Dunn: Sure. Hybrids are a very unique type of security, and they’re issued by companies and financial companies like banks. But generally speaking, banks are the biggest issuers of these particular types of securities, and at a very, very high level, they have elements of debt or bond securities, and they have elements of equity securities and they come together and they form this particular type of security called a hybrid.


    Phil Muscatello: And they traded on the the market, aren’t they?


    Brad Dunn: Generally speaking, they’re traded in the market in Australia, but that’s not always the case overseas. So we’ll get into that, I suppose, a little bit later. But in Australia, you will be very familiar with them trading on the exchange just like any other share.


    Phil Muscatello: So these instruments for companies and especially banks to raise capital now. I thought it was just on debt markets, you know, like in the fixed income ETFs that you manage or raising capital on the market itself. But this is another way that they can raise money. Is that the


    Brad Dunn: Case? That’s right. So hybrids have a very special purpose. So if you think back to about 2008, when we had what everybody knows as the GFC at that time, banks weren’t holding enough capital as they probably should to to hold against the loans and the and the assets that they hold. So the regulators took a look at this and they said, Okay, banks, you need to raise more of this type of capital that looks like a fixed income security for most of its life. But in the very rare circumstances where you need an injection of equity really quickly, what hybrids do is they can actually be converted to the equity or shares of the underlying issuer. So that is what their role is. So when you’re thinking about investing in hybrids, think about as you providing a service to the banks because those banks are holding that sort of capital and paying your return while they’re waiting on the very, very small chance that they would need your help to turn that into equity at some point in the future.


    Phil Muscatello: Has that ever happened?


    Brad Dunn: It has, but they’ve been very clear that they were going to do it and they did it in an environment where you received the the shares of the issuer, and you’ve got plenty of time to decide whether you want to keep them, whether you want to sell them on the market and receive your full value of of the hybrid back for them. So yes, it has happened, but it’s been very much in a controlled environment. It’s been very, very rare, especially in Australia, but also offshore, that they’ve needed to actually do this in a in a stress scenario where they’ve actually needed to draw on some of the features in the in the hybrid terminology.


    Phil Muscatello: I believe that these days there’s a question over whether banks and other companies can offer these directly to shareholders, as there have been in the past. What’s the situation developing now?


    Brad Dunn: Yeah. So if you’re a shareholder of any of the major banks, I think you probably would have at some point in the past received letters at home asking you, would you like to participate in one of these new offerings? And they would often have a fancy name like pearls or something like that. So you were given the option to do that as a as a valued shareholder of the bank. But in the last couple of months, in fact, in October of 2021, there were some rules changed about how financial companies and asset managers like ourselves can interact with and investors. And to that end, there’s a couple of acronyms there’s TMD and DDO. But what it means at the end of the day is that a bank or a fund manager like ourselves need to think very closely about who is the right market, who is the right investor to be offering our product or service to. And that is something that we’ve been thinking a lot about. But we think it also has implications for the banks because they need to think about would they be an investor that perhaps doesn’t have as much investing knowledge? Are they able to process the details in a fairly detailed letter about a new hybrid security? So that’s that’s certainly going on in the background, and it’s still an open question as to whether the banks are going to be willing to offer those types of securities into the future. Given this change in the rules


    Phil Muscatello: And because they are traded on the share market, there is a possibility that they will lose value at particular points in time,


    Brad Dunn: Of course, and that’s that’s the same with any with any traded security. And to be honest, once that actually lists on the exchange, there’s nothing stopping any investor from calling their broker or getting onto their their share trading account and buying it anyway. So it is a bit of an open question because as much as you want to offer these securities to the right people and protect them and make sure that they understand what they’re getting into. Once it once it’s listed, then it’s it’s fair game and it’s and it’s open season, basically. So it’s still an interesting development. But yeah, we watch this space closely.


    Phil Muscatello: What is the. Problem, then with an individual investor going on the market and just buying them just to get it, the rate of return because they offer a slightly better rate of return than a term deposit, don’t they?


    Brad Dunn: They do. Yeah. That’s certainly the appeal and why most people will look at them. I think the fact that they’re issued by really good quality names in the first place, I think, you know, but for but for a few people that have had some, some rough experiences with the banks, most people overall have quite a positive view about the actual strength of the banking system here in Australia. You know, it’s well run, it’s well capitalised, and people generally trust that the institutions will be here one year, five year, 10 years into the future. So that’s not necessarily the biggest issue. The biggest issue with hybrids is when you see a new offering. The the document that comes with it is generally 150 pages or or more, and that’s what can trip people up. Because while there is a fair degree of standardization, there are things that can change. And if you don’t have the time to sit down and read 150 pages, you may miss one of those little nuances and it could come back to haunt you in the future.


    Phil Muscatello: Mm-hmm. So of course, in all these situations, active managers can add value to a basket of hybrids. And that’s what you’re offering, isn’t it?


    Brad Dunn: Yeah, exactly, exactly. So that’s what I spend a lot of my time doing. So I spend a lot of time in these documents, so I know where to look. I know where the changes happen because I’m familiar with a lot of them. You get, you get to know them. So that’s part of the value that we can add. But secondly, what we can bring is a much broader universe, and we start to look a lot more broadly because, you know, in Australia, we’ve got great institutions. We just don’t have that many of them. And to be honest, most of your listeners and probably most investors around the country, be it in their super fund, albeit in their personal account, they will probably have a lot of bank equity holdings already anyway of of the four majors and and the regionals and so on. So there’s that problem of concentration because everybody wants, you know, income in this environment. But to do it with the same limited amount of institutions as you already hold in your equity portfolio means that there is that concentration aspect that you need to consider as well.


    Phil Muscatello: What is the kind of return that Harvard’s offer?


    Brad Dunn: So at the moment, one of the issues we’re facing is that the bank bill swap rate or the short term interest rate that is very sensitive to movements and say the RBA cash rate is still quite low. There’s been a lot of talk recently about when the RBA is going to start moving. We don’t think it’s still for at least 12 to 18 months ourselves. We’ve still been fairly conservative in that respect. But with interest rates so low, all of the hybrids are priced off that interest rate. So you’ve got nothing to start with and then you’ve got the margin on top.


    Phil Muscatello: And what what is that margin?


    Brad Dunn: So the margin at the moment is somewhere between 2.5 and 3.5 per cent per annum.


    Phil Muscatello: That’s not bad, though it’s not considering you’re getting less than one percent in a term deposit.


    Brad Dunn: That’s true. That’s true. We’re always very careful to start comparing them to different, you know, products like that and term deposits, especially because they are very different and they do carry investment risk. So we just wanted to sort of put that out there. But the other thing is, if you talk to 100 people, you’ll generally get 90 different answers as to where they think they sit in the spectrum. So, you know, we obviously know that cash is safer than fixed income. You know, fixed income is generally safer, go quote unquote, then then equities or property. And then within that spectrum, where do you see it, hybrids? And as I said, there’s a lot of conjecture about where the right places to sit them. So when you compare it in that sense, there are some people that do like to compare them against cash and term deposit like investments. And there are some that see the the aspects of equity that can kick in in certain circumstances and place them further up the spectrum. And that and that just leads to a whole range of different conversations about whether they’re good value, what the relative value is like and where they actually fit in in a particular portfolio.


    Phil Muscatello: So what are your thoughts on inflation and interest rates? Do you think we’re going to go into a period of hyperinflation? There’s some people that think we’re going into a period of hyper inflation. Yeah, and other people think, Well, no, it’s not going to be the same as what it’s like in the past. How do you feel about it and where interest rates are heading?


    Brad Dunn: That’s a great question, and I think that anyone that can sit back and open authoritatively on this subject is probably making things up. It’s a really hard question to answer at this point in time. There are a lot of crosscurrents and there are a lot of moving parts. From our perspective, we think that inflation is not going to go into that hyper inflation type scenario, nor are we going to head into what’s called a stagflation free environment. So stagflation environments are probably the worst of all environments for investors because you’ve got that combination of very stagnant growth and high inflation. Now, while we say that is, we still think there is an element of of transitory nature to the to the inflation aspect. But what we also don’t want. To forget is that there are some real factors as well, larger factors that continue to track on their merry way that have been disinflationary in the past. So the two that I’ll mention is the general indebtedness of the world. So, you know, countries and companies and individuals sometimes have taken on a lot more debt to get their way through the pandemic, and debt doesn’t magically just disappear.


    Brad Dunn: It needs to be paid off, and that takes time. And the second one is demographics. So the from what we understand, the the global or the workforce in China, for example, actually peaked a couple of years ago. So there’s actually sort of less new people coming into the workforce in China as there are older people leaving it. And that has implications for the world as well in terms of being able to manage the amount of output that comes out of of China and some of the other effects that that happened there. So demographics is another big factor that can influence inflation and interest rates rather than just what’s happening about not being able to get your Christmas presents here by December 25th this year, which is, I think, going to be a problem for for people in the short term. But we we caution against having that cloud some of the larger movements that are still happening that we think will impact inflation and interest rates as well.


    Phil Muscatello: Yeah, or the price of turkeys for Thanksgiving this year in America.


    Brad Dunn: Exactly. Yeah. All of those things, yeah.


    Phil Muscatello: Let’s talk about the argument for global and local hybrids and mixing them up in a portfolio.


    Brad Dunn: When we looked at putting the Daintree Hybrid Opportunities Fund together, we we looked very closely not just at the Australian scenario, but it’s not just banks in Australia that need to raise this capital, it’s actually banks around the world. The regulation that’s driving this is actually global. So we looked at banks and we wanted to identify banks that were similar to the Australian banks in one or many ways. But that also offered these hybrid securities because we thought if we could put a portfolio together of those high quality banks around the world, we could start to generate some true diversification rather than just saying we held 25 percent CBA, 15 per cent NAB. That was our diversification argument. We could say not only do we own the best Australian banks, we’ve also gone to Canada. We found the best banks in Canada with a system that’s very similar to Australia in a lot of ways, and we include them. We go to the United States, we find some great banks, they’re household names and we do the work and we find some of them that issue a hybrid securities to our liking as well. And we go to Europe and we do the same thing. So we’ve taken those steps.


    Brad Dunn: And what we found was the the way that hybrids are treated and priced and traded offshore is often very different to Australia. The ownership base is different. So in Australia, it’s generally mums and dads, self-managed super funds and smaller shareholders. So you’ve got a very, very broad, diverse ownership base that are very attracted to the franking credits, which which come with Australian hybrids, but they’re generally very much buy and hold. So they’ll buy them, take the coupon, put them in the bottom drawer and generally not trade them. When we look offshore, what we find is that the trading environment is very different. There are different investors involved, there are institutional investors, and they have a very different outlook on hybrids. They will be very much about the returns. So if the yield that they’re being offered isn’t what what’s up to scratch, they will sell and they’ll move on to something else. If the yield being offered is really attractive, then they will buy as much as they can find in the market. So it’s a very different type of scenario, and that gives us additional opportunities not just to find great securities to add and mix with Australian securities, but also to find yield advantages because


    Phil Muscatello: Presumably they’re sometimes they’re going to be trading lower and offering a better yield. Is that the case?


    Brad Dunn: Yeah, yeah. And it’s been quite consistent, actually. It’s really interesting to see that the the yield uplift or the yield differential that you can achieve from a security that is similarly structured. So we’ve read the terms from a similar issuer and all of those things, we match it as much as possible, but we can get 70 basis points, 100 basis points up to 140 basis points of additional return by adding these these offshore banks. Mm-hmm.


    Phil Muscatello: So that kind of like buying something less than its net asset value? Kind of.


    Brad Dunn: Yeah, kind of. Yeah. But when you look at it, you get


    Phil Muscatello: Return value or whatever the technical term is that I don’t know.


    Brad Dunn: Yeah, I mean, you can position it in a whole number of ways. But the way we look at it is if we were to take two banks and we took the names off the top so we wouldn’t be able to identify from the numbers themselves who they were. If we could find two banks that were remarkably similar, one was issuing a hybrid with a yield of 3.5 per cent and one was issuing a hybrid with the yield of four point five percent. Then, you know, it’s pretty obvious which one we would go for. So that’s really our approach. We’re not necessarily taking very much a brand name view. We don’t want to say that we hold all the best brands and here are all the logos. All we want to say is we want to get the best out of the. Hybrid asset class. And that means we have to look offshore and we need to take that into account, bring it all back to Australian dollars so we don’t take any currency risk. And once we’ve done all that, if we can find better yields offshore, then we will own them.


    Phil Muscatello: So what’s the criteria that you use to identify banks that are similar to ours?


    Brad Dunn: Sure, it’s a number of ways that we use. First, we look for legal structures that are similar to Australia. So Canada, for example, I mentioned that earlier. That is a Commonwealth country. So, you know, Commonwealth style legal system. So that’s all very, very similar to us, very familiar to us. Its housing market is very strong, so there’s a lot of demand for residential housing. The Canadians love their houses just as much as we do. And also the the banks themselves. It’s what’s called an oligopoly style structure. So there are three or four large banks that hold a predominant amount of market share. But there is that vibrant secondary level as well, where there are some smaller banks and some non-banks and whoever that sort of compete in the market as well. So market structure very similar to and we think that’s good because having those four four pillars, if you will, in Canada provides that stability to the to the system.


    Phil Muscatello: Do they have a four pillars like we do?


    Brad Dunn: They don’t have a four pillars policy, but it turns out that they’ve got four banks that are much larger than the rest. So it’s a de facto four pillars in that sense.


    Phil Muscatello: What are some of the names of the banks that are in the portfolio?


    Brad Dunn: Yeah. So at the moment, we’ve got JPMorgan Chase and Bank of America in the United States. We have Royal Bank of Canada and the Toronto-Dominion Bank in Canada. We have a bank called ING Group out of the Netherlands. We’ve got a really interesting bank called Swed Bank out of Sweden. The interesting part about Sweden is they’re regulated, so their version of of APRA, their bank regulator, is so particular about the amount and level type of capital that they hold, the amount of hybrids they can issue, the types of hybrids they can issue. They are so particular and so overbearing on the banks that they hold so much capital they don’t know what to do with it. And for us that that’s really appealing because, you know, they could live through a nuclear winter, a volcanic eruption, an earthquake, some


    Phil Muscatello: Zombie


    Brad Dunn: Apocalypse, zombie apocalypse, anything. Yeah, and they would still probably survive. That’s how much capital they’ve got. So, you know, that’s that for us is, you know, a very appealing thing for us as a hybrid investor. So, you know, those sorts of things come into our thinking when we when we look at names.


    Phil Muscatello: It’s the portfolio manager, how do you manage risk in constructing the portfolio?


    Brad Dunn: A number of ways. First of all, we use all of our standard measures. So proper diversification a good fundamental process to weed out the the good from the bad, the wheat from the chaff. And that’s been pretty successful to get us down to a good, manageable group of names that we can then add to the portfolio. On top of that, we use something called our overlay, so I’ll explain what an overlay is in a minute. But the overlay is there to not only add an additional little return stream, but also to manage risk. And I’ll I’ll explain what that means in a little bit more detail. And then the third thing we do is we have what’s called a tail hedge or a or a tail cushion. What it does is it’s there for when markets decide in their infinite wisdom out of the blue to drop by 15 or 20 per cent in the space of a week. Because what we know is that hybrids will often go with that with that market drop, and that can be quite affronting to to an investor that’s owned a hybrid for a couple of years has gotten relatively comfortable. Their coupons have landed on time and everything’s great. And then all of a sudden we see the value of them drop by five or 10 per cent.. It has happened in the past, and I’m reasonably certain that it will happen again in future. It’s just par for the course. But within our fund, we have the tools to actually put a little protection mechanism there. So if that event did occur, we’d be able to dull some of that volatility, you know, in our returns because ideally we want to reduce the drawdown because the most difficult part of recovering from that drawdown is is getting back to getting back to level.


    Brad Dunn: You know, a 10 per cent fall requires way more than 10 per cent return, 10 per cent upside to get you back to to level pegging. Yeah. So we want to avoid that as much as possible. So there are the three ways we do it. But just to maybe go back to the overlay and give it a little bit more context. So we know that hybrids often perform like fixed income securities, but when markets get tough, they start to begin to act like equities. But it’s often at the times you least want them to. So what the overlay says is that hybrids have a particular type of structure. What we can do is we can put some trades in that go against that, that go counter to what we think will happen in that downside environment to protect us against some of that volatility. Now it sounds complicated and we’ve got, you know, two people at Daintree that do that. Specifically, they spend a lot of time thinking about what’s the best way to do that? What’s the cheapest way to do that? What’s the most impactful way to do that? And at the end of the day, we want to, as I said, trying to remove some of the volatility that comes from from these securities and make them look and feel as much like a fixed income security is as possible to give you that extra level of comfort.


    Phil Muscatello: When is that? Is that like hedging? Is that what’s called hedging?


    Brad Dunn: You know what it is hedging? Mm-hmm. But our overlay programme tries to do that and more so to


    Phil Muscatello: Generate it more of an income as well.


    Brad Dunn: That’s right. Yeah, we want to be able to offer regular and stable coupons. We want to be very clear and be able to do that. And of course, our hybrid book will always generate that coupon for us. But if we can add a little bit of additional income onto that, then in this type of yield environment, I think that’s going to sort of be a lot more valuable than the sort of the 100 basis points or so that we’re actually talking about will, will, will generate because that 100 basis points, that’s that’s one percent or so. That’s largely what you can get for a long term cash deposit at the moment. So hybrids plus that little protection mechanism coming together to really sort of provide that that service or to extract the full potential out of hybrids is the way we like to put it.


    Phil Muscatello: What’s a coupon?


    Brad Dunn: Oh, it’s just it’s just a distribution payment in bond world. In fixed income world, we call them coupons. It’s also another name for distribution or an income payment.


    Phil Muscatello: So how does DHOF compare to other hybrid alternatives?


    Brad Dunn: Well, it’s a mixture of some of the best aspects of hybrids. So compared to alternatives, they generally either look fully international or fully Australian. And DHOF has that mix between local and global. To the best of our knowledge. Our peers in the in the space also don’t have that protection or overlay mechanism in place. So they tend to, you know, build a portfolio of assets and then generate the coupon the the income payments and then generally don’t have any other things around that. So you get to ride the wave of the of the ups and the. Downs, so adding, adding that element to us, I think, differentiates us as well. And the point to note is Daintree Capital has partnered with the Invest for for many years and DHOF is our third fund. And in our other two funds, we have the same overlay program running. And it’s got several years of track record behind us now. So we’ve tested it in real world environments. We’ve tested it in 2017 2018, for example, which was an interesting time in credit markets and it seemed to have, you know, come out of that quite well, and we’ve learnt a lot from that. And of course, 2020 got another good test of the of the program. So it’s had some real world experience. So we’re confident that including it in d off will give us that, give us that result that we need and differentiate us from the market as well.


    Phil Muscatello: So even though hybrids are traded on the market and have the same market risk, they can go down when the rest of the market goes down. Presumably, if you hold on them onto them till the end that you get your original capital back the way they work.


    Brad Dunn: Yes, and that’s been overwhelmingly the case for for many years. But there’s there’s definitely a few terms and a few dates that you need to look out for and be familiar with.


    Phil Muscatello: Yeah. So this is in the 150 pages.


    Brad Dunn: That’s right. That’s right. I’ll try and summarise about 50 pages for you in a few minutes. But the first date to note is what’s called the call date. So the call date is the first date that the issuer can say, Okay, we’ve decided that these securities have played their part and it’s time for us to redeem them, to buy them back from you, in which case at a call date, they can say, we’re going to pay you the par value, the face value of the of the security plus the final distribution, the final payment. So you’ll come out square and received all your year income payments along the way. So the call date is very important, but the call date isn’t mandatory. The call date is only optional. The issuer can still say, Well, we like these securities. We like having you as a as a hybrid holder. We’ll decide to not call these in which case they will trade on January for another one to two years. Ok, so you need to be aware that that call date is not an end date, but generally after that, after another two years is passed, we have what’s called a mandatory call date. So the mandatory call date will happen. You will get your money back and you will get your final coupon subject to a couple of criteria being met.


    Brad Dunn: Generally speaking, it’s that the the bank’s share price is above a certain level, which is generally an easy threshold to make. But it’s just something there to to be aware of and needs to be met, and that the regulator says it’s okay for them to do it. And it’s generally because they’d be replacing it with something else, or they’ve raised a different piece of capital somewhere else. So the bank would be in no worse position by redeeming it. So that would generally happen at the mandatory call date. And then you’ve got what’s called the the actual legal date, which is perpetual. So there are some situations very, very rare where they can actually trade without a call date and they lose the call dates and they start to become what’s called a perpetual security. And if any of your listeners have ever heard of a code called NAB Aicha, they would know what I’m talking about because that was one of those rare securities back in the olden days, back in the late 90s where it actually lost its call dates and it became what’s called a perpetual security.


    Phil Muscatello: Is it still on the market?


    Brad Dunn: No. It eventually got bought back, but investors only needed to wait 20 years. So it was it was a long wait and there was a lot of ups and downs along the way. We had the GFC. We had other market ups and downs. We had the pandemic, but it was eventually brought back by by that bank. So it’s just one of those things that you need to be aware of, as I said. So if you’re aware of those key dates, you’ve got a broad idea of of what you could be in for.


    Phil Muscatello: However, if you don’t want to worry about all of that sort of stuff, you can go to an ETF to have this all managed for you.


    Brad Dunn: Yeah, absolutely. So we think it’s one of the ways that actually we can help our investors as well because, you know, the paperwork involved can get tiresome and you probably got paperwork coming out of your eyes already anyway. So I hope the discussion today hasn’t necessarily scared too many people away from hybrids, given that they can be a little bit technical. But yeah, the reality is with with the click of a mouse and the trade of a single security via via dayof on the ASX, you can get access to that asset class. Have someone like me working through the detail, creating a portfolio, accessing securities that you can’t from your share trading account or your stockbroker, and then having all of that protection underneath that as well. So if? We do see those market volatility events. You will be able to to watch and hopefully ride it out from the sidelines, you know, without anywhere near the level of volatility that others would be saying by simply buying a pearls 10 or buying an NAB hybrid and then just going along for the ride. So that’s yeah. So that’s definitely an appeal for the the one trade ETF structure


    Phil Muscatello: Without getting into the nuts and bolts of portfolio construction because we can’t actually construct anyone’s portfolio here on the podcast. But what kind of place does this ETF take? What part can this ETF take in? What part can this ETF take in someone’s portfolio?


    Brad Dunn: Sure. So I’ll just put it out there that this is general advice, of course, yes. But from our perspective, we think you should sit in the the income bucket, potentially also in the alternatives bucket. They they do have some features that would easily be able to classify them into the alternatives bucket if you if you take that view. But generally speaking, they should be looked at as income generating securities. But you need to understand that those income generating securities come with a little bit of market exposure, not the same amount as equities, but more than cash and more than a very high quality fixed income or credit portfolio. That’s that’s where they should see it, but they come with franking credits and they’re issued by great names. So putting that all together, I think you can be very confident to include them in the income part of your portfolio.


    Phil Muscatello: And how can listeners find out more about De Hoff? Where’s the web address that they can go to?


    Brad Dunn: Sure. I just need to get online and we’ll have lots of content there. Lots of information to get you started and hopefully convince you to to join our growing crew. And if listeners sign up before the 31st of December, we have a special offer. So if you buy units before the end of the year, we are offering a fee free for the first six months of 2022. So invest before 31 December. Hold your holding through to the end of June and then you will receive bonus units in July as a as a welcome to the as a welcome to the fund. All the details are in the PDS. Be sure to read that before taking any further action.


    Phil Muscatello: Bran, thanks very much for joining me today.


    Brad Dunn: Thanks, Phil.