This article appeared in the Australian Financial Review.
When the best term deposit rate you can get is below 1% from a bank you may never have heard of, the chance to get 4% or better on a hybrid security from one of the big four tends to grab your attention. The problem is, of course, those attractive rates come with all kinds of strings attached.
After emerging 25 years ago as a handy solution for companies to raise money and for share market investors to be able to access higher yielding securities, hybrids have become an entrenched part of the Australian market. However, while they can readily play a role in a smart investor’s well-structured portfolio, they are devilishly complex. There is a variety of structures and features requiring issuing documents that can run into the hundreds of pages, enough to prompt government websites like Moneysmart to describe them as ‘very risky’.
The ‘hybrid’ label is because they blend elements of debt securities and equities, that is, they are part bonds and part shares. Typically they promise to pay a rate of return, which you can think of as an interest rate, for a certain period of time, and at the end of that period, the investor gets the original face value of the security, which is normally $100, in shares.
The interest rate is usually quoted as a margin above the 90-day bank bill rate. Companies with a lower credit rating will have to pay a higher margin, just like a corporate bond. The rate can be fixed at a specific return, or it can ‘float’, meaning if the bank bill rate goes up or down, so too does the interest rate the investor receives. And hybrids commonly incorporate franking credits as part of the yield.
The rate a hybrid pays when it’s issued will normally be set by the issuer’s investment bankers going out to the market and testing investor appetite. Then once the security is trading on the market, the rate an investor receives will depend on the price they pay for the hybrid.
The part that makes hybrids complex and risky is the equity element. No two hybrids are the same, and the obligations of the issuer and the rights of the investor, can vary considerably. Some hybrids allow the issuer to stop paying any interest if it falls into financial difficulties, and some place the investor’s rights to recover their money in the event of the company failing behind all other creditors.
The theoretical price a hybrid security should trade at is determined by the combination of its starting margin over the bank bill rate, its different equity-type features and the length of time before it matures. The longer the time to maturity, the more time there is for something to go wrong and so the higher should be the interest rate.
The upshot of all these features is that hybrids are normally a lot more volatile than pure fixed income investments, but not as volatile as shares. When the ASX 200 fell 37% in February and March this year, the Betashares Active Hybrids ETF (HBRD) dropped by just over 15% and is now getting back to its pre-COVID levels, while the broader share market is still 14% below it.
Andrew Papageorgiou, a portfolio manager at credit investing fund manager Realm Investment House, said, “While hybrid prices do fluctuate, they are underpinned by solid mathematics. Like all securities, from time to time prices can be considerably above or below where we calculate they should be, which creates opportunities.”
This begs the question: if a self-directed investor doesn’t have access to the maths, how do they know when hybrids are cheap or expensive? The various stockbrokers that help sell new issues usually publish research showing the basic valuation measures, such as the current yield, and some of them may offer recommendations.
It’s worth bearing in mind, however, those brokers get paid commission to sell hybrid IPOs (an exception that was carved out from the recent reforms that saw LICs and LITs stop paying commissions), so there is an overarching question of conflicts of interest. There are other websites, such as yieldreport.com.au, that publish tables as well. Papageorgiou says a very rough rule of thumb is that normally bank hybrids, which dominate the Australian market, should generally trade at a margin of about 3.2 to 3.3% over the bank bill rate.
A few years ago Australia’s bank regulator, APRA, introduced clauses into bank hybrids enabling them to stop interest being paid or even to compulsorily convert the hybrids into shares if the bank’s senior equity falls below certain levels. ASIC expressed great concern that investors wouldn’t understand the risks and that hybrids were being marketed as an alternative to term deposits. To be clear, buying a bank hybrid is nothing like placing a term deposit with the same bank. A term deposit is government guaranteed (up to $250,000) and its value doesn’t change on a day to day basis.
However, asset allocation consultant, Tim Farrelly, argues the kind of market events required to trigger the conversion clauses are so extreme, and APRA is sufficiently vigilant, that investors shouldn’t lose sleep buying a bank hybrid provided they are comfortable holding it until maturity. That way they can ignore the market volatility and enjoy the added yield of a defensive, investment grade security. If you don’t think you can stomach the potential for 15% drops in the defensive part of your portfolio, no matter how temporary, then don’t go there.
Want to find out more about your investment options and whether hybrids could work for you? Get in touch today.