Many yield-focused investors have gravitated toward hybrid securities in recent years, but most people do not take the time to really understand some unique features contained deep in the offer documents of these securities. This article aims to cut through the jargon and complexity to provide a clear picture of a hybrid security from an investor’s perspective.
What is a hybrid investment?
As the name suggests, hybrids combine elements of debt and equity securities. In Australia, they generally pay a floating-rate distribution in the same way as a floating-rate bond, but they do not have an official maturity date (fixed date), which we classify as a decidedly equity-like characteristic.
Hybrid securities, therefore, have the ability to offer the best of both debt securities and equity securities – they pay an interest rate that generally has a higher rate of return than most corporate bonds and, certainly, bank’s term deposits. On the other hand, the ability to convert into ordinary equity gives hybrid securities more flexibility and a ‘stock-like’ feel with lower levels of volatility.
This unique combination with this type of financial product creates diversification for investors which can help inventors better manage risk. However, hybrid securities also add another layer of complexity which many investors might not be familiar with. The complexity can come about because no two hybrid securities are the same. They all have different terms which might not always work out in the investor’s favour.
It is this level of complexity and different terms and conditions that allows professionals to identify opportunities where these investment products might be mispriced.
Types of hybrid securities
There are three basic types of hybrid securities – convertibles, preference shares and capital notes.
A convertible debt security (convertible bond) is one that allows the holder to convert it to another type of security at a certain date in the future. The ability to convert a debt security into ordinary shares is an example of how a hybrid security is able to manage risk, while still being open to the upside from the equity conversion.
Preference shares are similar to ordinary shares that pay regular dividends, though a preference share will normally pay a specific dividend rate. The rate could be fixed or floating and preference shares are often able to be converted to cash at maturity in a similar fashion to a bond.
Capital notes are debt securities, however they have features that make them act like equities.
Capital notes include perpetual debt securities, which don’t mature, subordinated debt securities which are ranked behind other types of debt, or knock-out debt securities which give a third party (like APRA) a right to extinguish them under certain conditions.
Who issues hybrid securities?
It also is worth discussing why hybrid securities are issued. Banks and other financial companies monitored by APRA are by far the most common issuers, which they undertake to meet regulatory requirements on the proviso that the securities are structured in a certain way. It is these requirements that make hybrids so complicated for investors.
Three of these requirements deserve special mention:
The ability of the issuer to cancel distributions.
This is actually quite easy for the issuer to do in theory, however, they would have to also suspend paying dividends to ordinary shareholders – a choice that would undoubtedly have other ramifications. If hybrid distributions were ever cancelled for a significant period of time (say greater than 12 months), it is also possible that those missed payments may never be made.
APRA’s discretionary power to convert hybrids to equity.
Hybrids are designed to be “loss-absorbing”. In simple terms, this means they are designed to be a reserve source of ordinary equity should the issuer ever get into significant trouble, or the bank becomes insolvent. Having this reserve equity on hand, so the theory goes, means it would be less likely that taxpayer funds will be required to resolve a stricken financial institution. There are some details around when this conversion may happen, but significant discretion remains in the hands of APRA, a risk which is almost impossible to price.
The possibility that share price movements can delay a conversion or redemption indefinitely.
Australian hybrids are designed to have optional and mandatory dates where the issuer can repurchase the security or convert to equity. However, for this to happen the equity share price needs to be above a certain level before any such event can occur. The relevant equity price levels vary by hybrid, making it difficult to clearly ascertain whether a price threshold is proximate. On any exchange today there remain examples of hybrid securities that continue to trade despite having already passed several “call” dates.
Advantages and disadvantages of hybrid securities
Benefits of hybrid securities
- Income-producing with fixed or floating rates which are often higher than standard corporate bonds.
- Some hybrid-securities offer franking credits, however, this will vary between issuers.
- Reduced volatility – a debt security with the ability to be converted into an ordinary share can offer improved risk-reward scenarios for investors.
- Exchange traded – listed investments allow the hybrid investor liquidity compared to other investment options.
Risks associated with hybrid securities
- Coupons are not always guaranteed, so this is a risk if the issuer decides not to pay coupons.
- Hybrid securities are subordinated debt, meaning they sit above equity but below other forms of debt.
- Redemption can be delayed by the issuer.
Actively managed hybrid securities
Some of the key risks with hybrid securities can be improved through diversifying. An active manager can assist in identifying hybrid securities that might be mispriced while building a portfolio to reduce company risk that might be present.
Despite the intricacies of this type of financial instrument, we expect hybrid securities to remain popular, especially for investors that can utilise franking credits.
We believe the hybrid market falls much closer to the equity side of the spectrum, however, they can offer a good risk-reward with income-producing potential for retail investors.
Disclaimer: Please note that these are the views of the writer, Jodi Pettersen, Investor Relations at 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 www.einvest.com.au. If you’d like to keep learning further, please feel free to follow any of our socials listed below.