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Hybrids in the Fast Lane


by daniel archibald

Uncertainty, volatility and poor macroeconomic policy have created a troublesome environment for investors and those living off their assets.  This is especially true for those who have ended their relationship with the working world and whose “wages” are now in the form of interest, rent, dividends, and distributions.  Furthermore, with interest rates on the decline and the competitive drive taken out of the term deposit market, protecting income streams has become the prevailing trend. 

The current turmoil and lower deposit rates has lifted the profile of income producing equities and higher yielding securities.  Of particular importance to today's investor is the class of assets referred to as hybrids.  

Hybrid shares are the general grouping of fixed and floating income securities that are listed on the ASX.  The name is suggestive of their dual characteristics - part bond, part equity - with most classed as fixed income.  Essentially, they are subordinated debt or bonds issued by companies and traded like shares.  Most of the current issues pay a coupon at a set margin above the 90 day or 180 day bank bill floating rate, but there are also some fixed coupon issues.  Also, some issues have conversion rights attached, allowing the security holder to swap the hybrid for shares in the actual company. 

In a recent media release, the Australian Securities and Investments Commission (ASIC) has urged investors to gain a greater understanding of the conditions and risks of hybrids.  ASIC Chairman, Greg Medcraft emphasised “… investors may be attracted by the interest rates offered… but hybrid securities should not be confused with government bonds or ‘vanilla’ corporate debt”.  

Hybrids generally fall into 2 categories, preference shares or income securities.  The former relates to shares issued in a company that pay out a set dividend and mature at par value (similar to a corporate bond).  Preference shareholders also rank higher than ordinary shareholders in liquidation proceedings.  The latter are much more like regular bonds and rank above all shareholders.  Altogether, there are 5 major types of hybrids.  These are as follows: 

Converting Preference Shares - these are the traditional 'hybrid' shares due to their greater equity characteristics.  As these shares can be converted at some future time into equity of the issuing company, the price of these can be affected by the underlying share price and can trade more like equity than fixed income;

Step-up Preference Shares - these will pay a higher coupon rate should they not repay shareholders in full at maturity (known as "stepped-up" preference shares if this occurs);

Reset Preference Shares - these will tend to rollover into new issues at new "reset" rates and can be seen as having no real maturity date (perpetual);

Perpetual Income Securities - these have no maturity date and will generally pay a floating rate of interest; and

Debt Income Securities - these are essentially corporate bonds listed on the stock exchange. 

The main attractiveness of these types of securities is in the yields investors may expect to receive.  One measure of yield is the "current yield", which is simply the coupon rate to the current price.  This yield does not take into account fully the fact that the security might be trading at a discount (or premium) to the maturity value and therefore may also provide a capital gain (or loss) to the investor should they hold to maturity.  The "yield to maturity" measure helps to capture this added dimension. 

The main risks inherent in hybrid securities are two-fold.  First, similar to debt issues of any kind, the investor faces credit risk (i.e. the risk that the borrower won’t repay the loan and/or interest repayments).  Secondly, added onto this credit risk is the fact that most hybrid issues rank below secured and unsecured debt, meaning that in the event of liquidation, hybrid shareholders may not receive any of their capital until after all other creditors and bondholders have been paid in full (though they should get paid in full before ordinary shareholders get anything).  Because of this debt subordination risk, hybrid securities should be expected to compensate investors with a higher rate of interest when compared to other secured and unsecured debt or bonds. 

There are currently around 50 hybrid share issues trading on the ASX, with 11 of these being from the big 4 banks.   These bank hybrids are some of the more higher rated issues.  There are also some lower rated securities providing higher yields as a trade-off for higher credit risk.  With many of the major bank hybrids providing gross yields to maturities of almost 3% above their respective deposit rates, these income bearing securities are expected to become more popular amongst investors and also as a means of raising capital for corporations.  And even though hybrids will tend to be far less volatile than equities, as they are traded on an open market, care should be taken to avoid transacting when there may be mispricing due to low volumes or market moving trades.

 

LBW Financial Services Pty Limited is a Corporate Authorised Representative of Wealthsure Pty Limited (AFSL Lic. No. 238030)

LBW Financial Services Pty Limited is an authorised representative of Wealthsure Pty Ltd, AFSL 238030, ABN 93 097 405 108.  The information contained within these articles is of a general nature only.  Whilst every care has been taken to ensure the accuracy of the material contained herein at the time of publication, neither the author, authorised representative, nor licensee will bear responsibility or liability for any action taken by any person, persons or organization on the purported basis of information contained herein.  Without limiting the generality of the foregoing, no person, persons or organization should invest monies or take action on reliance of the material contained herein but instead should satisfy themselves independently of the appropriateness of such action.