Hybrids are securities listed on the ASX that have elements of both debt and equities. They have experienced a significant increase in market size and popularity in the past decade, however they are not straightforward investment.
The reality is that hybrids carry with them significant complexity, and so a thorough research process for these securities is vital.
In this article, we will share how Lonsec, as a research house, goes about its hybrids research process. This can provide DIY investors with a framework that they can compare to their own, or tap into to enhance their selection process for hybrid securities.
Lonsec’s listed income research follows a structured framework to derive an investment rating and risk assessment. The investment rating is a long-term assessment which remains relatively static, though will be upgraded or downgraded should our ‘investment grade’ view change.
The risk assessment is more dynamic, and may vary more frequently throughout the term of the issue. In forming our investment rating, we have assumed that positions are held to maturity and therefore will continue investment coverage through to maturity.
Each listed income investment under coverage is assigned either an ‘Approved’ or ‘Not Approved’ rating.
The ‘Approved’ rating indicates that Lonsec believes the security is of ‘Investment Grade’ quality, meaning we believe the security will pay all distributions in the term to call and holders will receive face value on maturity, such that the income potential outweighs the potential risks.
The ‘Not Approved’ rating indicates that Lonsec believes the security is not of ‘Investment Grade’ quality, meaning we believe the potential risks outweigh the long term income potential of the security. These recommendations are made with reference to the Lonsec risk assessment, which is discussed below, and with consideration to the relative attractiveness of the expected return.
The potential return refers to the interest margin on offer over the relevant benchmark rate and any other investment return which may include conversion discounts, in-built call options, entitlements to IPOs and future step-ups in the margin.
The six risk categories identified and assessed (in order of importance) are:
The financial strength of the financial product issuer is examined according to the sector in which the company operates. This is primarily designed to ensure the analysis represents a true reflection of the financial product issuer’s financial strength and to take account of the fact that banks and insurance companies have very different financial structures than traditional industrial companies. Specifically, the key indicators analysed include balance sheet strength, wholesale credit rating, capital adequacy ratios, interest cover, asset quality, liquidity, net tangible assets, gearing and earnings quality.
The risks inherent in any listed income security can vary significantly based on the security structure. To assess structure risk, Lonsec examines subordination / capital classification, distribution payment tests, distribution restriction conditions and conversion conditions.
The risks associated with the maturity structure of the issue are examined in detail and a relevant risk rating assigned. One of the key factors in the market’s pricing of a listed income security is the maturity terms and conditions, as these determine the ‘how’ and ‘when’ the invested capital is returned to the investor. Lonsec forms a view on the expected maturity date of each security, having considered the maturity and / or conversion terms, the financial capacity of the financial product issuer, the ascribed equity credit and the significance of the size of the issue to the financial product issuer.
Liquidity risk is the risk that an investment may not be easily converted into cash with little or no discount to the last traded market value, and at minimum delay. A liquidity premium should be required by investors to compensate for lack of liquidity. Low liquidity can also result in higher than desired volatility. Key attributes analysed to rate liquidity include issue size and average weekly turnover.
Structural and operational risks associated with the industry in which the company operates can impact the financial position and prospects of the financial product issuer, and hence the performance of the listed income security. Industry analysis involves consideration of the following factors: current and forecast industry conditions, domestic and global economic outlook and its expected impact on the industry, regulatory risks, the company’s positioning and pricing power within its industry, the power of suppliers and buyers, as well as the life cycle stage of the industry.
Volatility measures how much the market value of an issue fluctuates with respect to its face value over the life of the issue. Volatility is often viewed negatively in that it represents uncertainty, however, it can also provide the potential for higher returns. Both capital and income will contain some degree of volatility depending on the nature of the underlying investment. Our assessment of expected volatility takes into consideration a number of metrics including financial product issuer strength, economic and credit market conditions, investor sentiment, equity market conditions, the perception of or likely occurrence of distribution deferral or a conversion trigger, capital ranking / structure, liquidity, conversion terms, maturity risk and the volatility of listed peers.
Following an assessment of the risks and metrics described above, a risk ranking score is assigned to each of the six risk categories. The risk rating categories range from Low to Speculative, and are described below:
A low risk assessment indicates that a majority of the risks are rated as low which indicates strong credit quality.
A moderate risk assessment indicates that a majority of the risks are rated as moderate which indicates good credit quality.
A high risk assessment indicates that a majority of the risks are rated as high which indicates low credit quality.
A speculative risk assessment indicates that a majority of the risks are rated very high which indicates the issue is below investment grade and has speculative qualities.
Lonsec also advises on the Lonsec investor risk profiles that each security is suited to.
Lonsec’s Hybrids Viewpoint reports bring all the above research points together into one snapshot report, and enable DIY and SMSF investors the ability to quickly absorb the most relevant information for each one.
As evidenced from all the above, the hybrids research process can be a time consuming and resource intensive task at the professional level.
Thankfully, the outputs of Lonsec’s research process are now readily available to DIY and self managed investors. The hybrids research table provides the ability to filter hybrids by a range of criteria, along with the downloading the viewpoint summary reports, and a model portfolio of best ideas.
CLICK HERE to find out more about the full spectrum of research available.
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