Investing in hybrids
Hybrids (also known as Listed Income Securities) are a type of security listed on the ASX that have become very popular with SMSF investors over the past decade. They are securities that have historically been bought for the relatively high level of income that they generate, compared to other fixed income type investments.
However, hybrids are not simple investments, nor are they risk free. As such, it is important for SMSF investors to understand that they are getting into when they decide to invest in hybrids.
Fixed interest like qualities:
The main reason hybrids are often thought of as being like fixed income is because they pay income – either at a fixed rate or a floating rate – and promise to pay back the principle (at face value, usually at a price of $100) at a maturity date in the future. They also have what is called a “call” date where, at the issuers discretion, they can pay this principal back early (and usually do) which is most often five to seven years. The price of the hybrid is generally fairly stable when overall economic and market conditions are stable, however this can change when economic or market conditions become very volatile.
Share like qualities:
On the flipside, hybrids can also have some equity (or share) like qualities. Whilst some hybrids pay interest, some others pay dividends, similar to shares, and are often 100% franked. Some may also convert into ordinary shares before a maturity or call date, depending on their conditions. And some legacy hybrids on the ASX are perpetual securities, meaning they have no maturity date.
On the risk vs return line, hybrids sit below shares and property, but above fixed interest.
Low risk/return High risk/return
Whilst there are a range of companies that have issued hybrids on the ASX as a way of raising capital, just a cursory glance of this market shows that it is dominated by Australian banks.
Banks are required to maintain what is known as “regulatory capital”, and hybrids form part of this.
The following graphic shows the capital structure of banks. Hybrids are generally either additional tier one or tier two capital. As you can see, they sit in between shares and bonds (debt).
Hybrids that fall into the “Additional Tier 1” category are just one step removed from ordinary shares, and as such typically pay their income in the form of franked dividends, just like shares.
However, those hybrids that fall into the “Tier 2” category are just one step removed from debt (fixed interest or bonds) and as such generally have fixed maturity dates and pay their income in the form of interest, just like fixed interest (and hence are not franked).
The income paid on hybrids can be either fixed or floating. The vast majority are floating rates, whereby they pay a defined amount (for example, say 2.5% pa) over and above a fixed interest benchmark such as the 90 day BBSW (bank bill swap rate). This means as interest rates go up, they pay more income. If rates go down, they pay less.
The names given to hybrids tend to fall into one of three categories:
The first two (capital notes and convertible preference shares) are the more equity like and tend to fall in the “Additional tier 1 capital” category we mentioned above. They tend to pay franked dividends, often have an option to either repay the face value or convert to underlying equity at their discretion, and there is no absolute obligation to have to pay distributions. Although note that a condition is often that the dividends of the normal ordinary shares cannot be paid unless the dividends of the hybrids have been paid. This is sometimes known as a “dividend stopper”.
Subordinated notes are more debt like, or bond like, and tend to fall in the “Tier 2” category mentioned above, paying interest rather than dividends, with more of a fixed term with its maturity.
One of the main risks with hybrids, particularly the Tier 1 capital hybrids, is conversion risk whereby the hybrids have been converted to ordinary shares, due to what is called a ‘trigger event’. For banks, these can happen due to the bank’s core capital dipping below a certain level, or the bank becoming what’s called “non-viable”. In this scenario, it is highly likely the investor would face significant capital loss.
Hence, if the economy is entering a recessionary period and the price of the ordinary shares of the company are falling by a large amount, the risk’s of the hybrid hitting a trigger event start to escalate rapidly, and hence the price of the hybrid can start to fall significantly too. This is where the “equity like” characteristics of hybrids really kick in and are fully felt by the investor, as the previous price stability of the security evaporates.
The terms of these events are quite complex and difficult to understand, and can differ significantly from one issue to the next.
Another risk of hybrids is liquidity. Some issues are quite small, and hence liquidity on the ASX for trading them can be an issue. Generally however, for the larger bank issues, liquidity for most individual investors is generally sufficient.
Concentration risk should be considered, given that the vast majority of hybrids on issue are from the banks.
And not to be forgotten, credit risk of the issuer is an important consideration (just like it is with fixed interest / bond) given the fact that the income payments are generally the main reason investors buy hybrids in the first place.
Using hybrids in the context of building a portfolio is often a difficult one for investors, due to the fact that their characteristics straddle both equities and fixed interest asset classes.
Should they used as a lower volatility portion of the growth/equities/shares part of the portfolio, or should they be used at the higher risk end of the defensive/fixed interest portion of a portfolio?
The reality is that they could be used as either. Or alternatively, give it it’s own special allocation.
However, what they should NOT be used for is as a complete substitution for the entire fixed interest part of a diversified portfolio. Whilst this can sometime be tempting given the ultra low interest rates on offer in cash and term deposits these days, remember that fixed interest is much more than that.
High quality Government and corporate bonds (including bond funds and ETFs), both domestically and globally, absolutely still have an important place in diversified portfolios. Hybrids are just another sub-sector asset allocation that can enhance yield and diversification in a well balanced portfolio.
As can be seen from all of the above, hybrids are not without risks, and its important for investors to fully consider each individual hybrid on its own merits before investing.
Lonsec are experienced hands with researching hybrids. We provide a comparison table with key data, plus Hybrids / Listed Income Securities Viewpoint reports. These reports are a two-page summary research report which includes of an overview of the security, key details, approved/not approved rating, risk rating, and commentary around the various risk categories of financial risk, structural risk, maturity risk, liquidity risk, industry risk, and volatility risk.
CLICK HERE for more information.
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