Head of Credit and Core
The Australian Securities and Investment Commission's (ASIC) repeated warnings about the viability of companies issuing hybrid securities may come as a surprise to many investors. Despite being issued by major banks and other reputable companies, ASIC stresses that many hybrid securities are not always ‘safe’, that is, returns are not guaranteed. Furthermore, the highly structured nature of these securities makes it difficult for some investors to adequately assess the risks involved. In this article, David Carruthers, Head of Credit and Core at AMP Capital provides an overview of hybrid securities and highlights what investors need to look out for.
5 things you need to know
1. Not all hybrids are created equal
Hybrids combine both 'equity like' and 'debt like' features. Hybrid securities – such as subordinated notes, capital notes and convertible preference shares – can be another way for companies to raise the capital required to fund their business. The number of hybrids on offer in Australia has recently risen to over A$4 billion (see chart below). Even though banks and other financials dominate issuance, investors should consider that each type of hybrid security has a unique risk and reward characteristic. Generally speaking, some hybrids will behave more like shares, and others more like bonds.
Source: RBA, Statement of Monetary Policy, May 2014. *Includes deals that have been launched, but not completed.
As with most investments, riskier hybrids tend to pay a higher interest rate (otherwise called a coupon or preferred dividend) to compensate investors for the added risk. When comparing hybrids to other investments, it’s important to consider whether the proposed return offers adequate compensation for the additional risks involved.
2. Hybrids can be highly volatile
Like shares, the market price of listed hybrid securities may fall below the price that the investor originally paid, especially if the company suspends or defers interest payments, or if its performance or prospects decline. Changes in the issuing company's share price and other economic conditions may also be reflected in the price of the listed hybrid security.
In the chart below, it can be seen that hybrids can experience excessive volatility during market downturns or the ‘repair’ phase of the credit cycle (this was particularly evident in the 2008 period). In some cases, investors can be left exposed to equity-like risk with only bond-like returns.
Source: AMP Capital, Bloomberg, as at 31 December 2013
3. Hybrids are generally less liquid than shares
While many Australian hybrids are listed on the Australian Securities Exchange (ASX), they are often less liquid than shares in the company that issued them. This means that there are fewer buyers and sellers in the market for this type of investment and investors that need to sell quickly, may have to accept a lower price.
4. Hybrids are often unsecured
Typically hybrid securities are unsecured, meaning that repayment of the initial capital or ‘principal’ is not guaranteed. In a wind-up scenario, hybrid investors are among the last to recover their funds since they generally rank behind senior bondholders and other creditors.
5. Hybrids can be complicated
Hybrid securities are known to be highly complex products. For example, some have contractual clauses that allow the issuer to exit the deal or suspend interest payments when they choose. Others may convert into ordinary shares, or be written off completely if the issuer experiences financial difficulty. It is critical that investors fully understand all the terms and conditions as these will have a significant impact on whether the hybrid meets expectations.
The ongoing search for income has led some investors to turn to hybrids. While these securities present an alternative source of income that is often higher than cash, they also come with additional risks and structural complexities. As such, hybrids require careful analysis to determine whether the return provided is sufficient compensation for the risks that investors bear.
Investors that value a steady return and capital stability may find hybrids unsuitable. Overall, we do not believe hybrids should be relied upon by investors as the sole source for a consistent and foreseeable income stream.
Important note: While every care has been taken in the preparation of this information, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This information has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Certain information in this website has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete.