Many yield-focused investors have gravitated toward hybrid securities in recent years, but most people do not take the time to really understand some of the 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.
As the name suggests, hybrids combine elements of debt securities 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, which we classify as a decidedly equity-like characteristic.
Before considering some of the finer details, it is worth discussing briefly 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 that they are designed to be a reserve source of ordinary equity should the issuer ever get into significant trouble. Having this reserve equity on hand, so the theory goes, means that 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 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 the any exchange today there remain examples of hybrid securities that continue to trade despite having already passed several “call” dates.
Despite the intricacies we have highlighted, we expect hybrid securities to remain popular, especially for investors that can utilise franking credits. A change of government at the Federal level may lead to a change of the imputation system, but we see the greater risks as those already in “plain sight”, requiring a reappraisal of the suitability and role that hybrids play in a broader portfolio. Given the arguments made earlier, we believe that hybrids fall much closer to the equity side of the spectrum.
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