Hybrids – what are they, why invest in them?
In this age of historically low interest rates, investors are struggling to find appropriately low risk investments which provide reasonable levels of income. The challenge has become even more difficult since the Reserve Bank cut the cash rate from 2.5% to 2.25%. Bank deposit rates are likely to fall further, creating additional pressure for retirees and others relying upon income to look further afield.
Hybrid securities can perform a valuable role for investors, delivering attractive yields and bond-like returns while also offering the possibility of capital growth. However they are complex instruments with many variations, and a thorough understanding of how they work can be of significant benefit.
The word “hybrid” is used in this context to describe a security that exhibits the characteristics of both debt and equity. Hybrids are frequently created by large corporations to raise equity or debt, and have elements of both. Hybrid securities generally provide higher yields than secured debt instruments to compensate for the higher investment risk. Thus hybrids can enhance the income returns of an investor, or be added to a diversified equity portfolio in order to boost yield.
However, investors should always be aware of the relationship between risk and reward. As with any investment, a higher return indicates a commensurate increase in risk. The key for investors is to avoid businesses that are unable to service their debt obligations. Assessing the credit-worthiness of a business can be a complex task, and thus investors should in most cases seek professional advice.
How are hybrids different to equities?
In general, hybrid securities have the following characteristics:
- They rank higher than equity in the company’s capital structure, but sit below secured and unsecured debt. This ranking reflects the rights of hybrid holders to be paid out before equity in the event of the failure or wind-up of a company. It is relatively rare for public companies to be wound up, but it is a risk that requires consideration.
- A hybrid security typically has a face value of $100. This is the redemption or conversion value if it is to be redeemed or converted into equity.
- Hybrid securities pay a regular fixed or floating rate of return or dividend until a certain date (unless they are “perpetual”, in which case there is no set date for repayment). Thus, holders are paid interest or dividends for holding the security for a predetermined period.
- At maturity or on a reset date, the issuer may have the right to decide one of the following options: convert the hybrid securities into the underlying equity of the issuer; redeem the hybrid securities, usually at face value; roll into another hybrid structure; or some combination of the above. Alternatively, the issuer may arrange a third party to purchase the hybrid from the security holders.
- In some circumstances, the issuer of the hybrid security can’t declare and pay a dividend for its ordinary equity unless the hybrid security’s dividend or interest payment is first declared and paid. Some hybrid distributions may be either cumulative or non-cumulative: a cumulative security is more valuable as unpaid interest may be an unsecured debt of the company in a winding-up.
- The issuer may suspend payment of dividends under certain conditions. The trigger for suspending payment can vary for each hybrid security, but the trigger conditions usually result from the issuer’s banker’s debt covenants.
- Most issuers retain the right to redeem perpetual notes early and will do so if attractive alternative funding is available.
A few different types of hybrids
Convertible Preference (financial) Shares (CPS)
These are the new style Basel III compliance bank Tier 1 capital notes being increasingly issued by major and second tier banks. They are considered as additional Tier 1 capital under the new Basel III regulatory bank’s capital requirement. These hybrids are higher risk than the older style Tier 1 capital issued prior to mid-2012 to 2013 (see below). In general, these hybrids have the following characteristics:
- They are issued with a term of at least 5 to 8 years and will mandatory convert into ordinary shares at this date or following an earlier Trigger Event.
- Usually two years prior to the mandatory conversion event, the issuer can opt to exchange the note for a cash payout. Exchange can also occur following a Tax Event or Regulatory Event.
Each individual security in this category will have different conversion or exchange conditions. In the main they should be considered to bear equity risk. Therefore an investor needs to understand the specific security risks and assess an appropriate rate of return for each individual security.
Step-up Preference Securities (non APRA regulated company)
These are usually issued by non-financial corporation with a non-call period of usually 5 years at the prevailing margin over say 90 or 180 days BBSW. At the call date, the issuer can opt to redeem them or step up the margin to compensate the holders for non-redemption. Once the margin is stepped up, these preference shares usually becomes perpetual unless they are being redeemed at some later date. In addition, it is possible that other events (such as a change of control occurrence) may also trigger redemption. This will be a stipulated term in the issuing document.
Convertible Preference Shares (non APRA regulated company)
Convertible preference shares are hybrid securities that convert into the underlying ordinary shares of the company after a certain fixed time frame, provided the conversion conditions are met by the end of the period. The conversion is usually priced at a discount. Under some conditions, the issuer can opt to redeem the preference share, although it is at the discretion of the issuer.
Subordinate Debt or unsecured floating rate notes
These are generally issued by large companies with well-known brands or franchises who tap the retail investment market. These companies usually have an investment grade rating on their senior debt. The issue of sub-ordinated debt (ranking behind secured debt) usually have the following characteristics:
- The interest is set over the benchmark 90 or 180 days BBSW
- The term is usually 5 to 7 years non-call period (i.e. non-redeemable period) but with maturity set at 15 to 25 years from the issuing date.
- On the first call date, there is usually a step up of the margin if it is not redeemed.
Since these instruments pay regular income which is classed as interest instead of dividend, these hybrids may be considered to have debt characteristics. Investors need to consider in determining the adequate rate of return. For instance the margin that these hybrids trade at is usually a function of several factors including credit rating and financial operating performance.
There are listed derivations of the unsecured floating notes (for example the perpetual note issue by NAB) that were issued by banks prior to the GFC. These are no longer able to be issued as capital under current Bassel rules because of their debt like trigger clauses or characteristics. These notes are usually perpetual and pay a quarterly distribution or interest priced at a margin above the 90-day Bank Bill Swap (BBSW) rate.
Key parameters to monitor hybrid securities
There are many factors one should be familiar with prior to investing in hybrids, among them the following:
Running yield – the yield of the security based on its market value. It is the anticipated income for investing in the security, expressed as a percentage based on the market value of the security at a moment in time.
Margin – the spread over a certain reference rate at which a hybrid is trading. This is in effect the running yield expressed in terms of a margin over bank bills. If the hybrid security pays a floating rate, the reference rate is usually the 90-day BBSW rate.
Credit rating – assists potential investors in forming a view of the creditworthiness of the corporation and its associated cash generation assets, and comparing them with other similarly rated securities. In general, the margin above the reference rate of a corporation and its associated securities decreases as the credit rating increases.
Duration to conversion, step up or redemption – Once issued, there is a point at which the hybrid is reset for conversion, redemption or a distribution step-up. Thus, while the current running yield may be an important parameter to monitor, the yield after the reset date is also important, especially if this date is less than two years away.
Balance sheet – Perhaps the most critical parameter with respect to a hybrid security is the amount of debt that a company is carrying. Generally, the lower the net debt to equity ratio, the higher the probability that the hybrid will avoid capital loss. As long as the underlying company is profitable, enabling it to service its debt obligations, the company is obligated to pay distributions to their hybrid securities owners.
The devil is in the detail
As mentioned above, hybrids are often complex and variable in their terms and conditions. In many cases, “the devil is in the detail”. It is advisable to carefully read the complete terms and conditions of the security, or rely on a professional and competent adviser.
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