All You Wanted To Know About Hybrids (but were afraid to ask)

WHY INVEST IN HYBRIDS?
General Overview

From an Asset Allocation perspective, the performance of the UBS Hybrid index (a measure of hybrid investment returns) has shown low correlation to other asset classes since it was introduced on 2 July 2001. Although the period of the data is very short, this provides tentative evidence that hybrids are useful for diversification purposes. Our calculations show a historical return of 7.3% pa with a standard deviation of only 3.3% pa since inception of the index. Furthermore, franking credits can add an additional 1.0% pa net on top of that. Most hybrid funds have a pre-fees target of 150-200 basis points above the bank bill index or composite bond index or a mix thereof. It is interesting to note that while investors’ participation in the bond component of the index has increased with the additional issuance of, e.g. Reset Preference Shares (RPS), those invested in the more equity like securities have been better rewarded. Step-Up Preference Securities are likely to increase in importance as banks use them for new Tier 1 capital instead of RPS. While Step-Ups are inherently more risky, the risk is manageable and with a good historical global track record, most managers are expected to selectively invest with them. From a Market Valuation perspective, the picture is much less rosy. Credit spreads for lower rated debt securities have contracted in Australia. Although spreads are not expected to widen significantly, the potential for further capital appreciation is limited.

From a Market Structure perspective, the UBS Hybrid index still consists of only 62 securities, of which only 34 are rated. Hence the market is still too small in terms of value, liquidity and diversity for institutional mandates. Some hybrid fund managers have overcome these shortcomings by complementing their funds with other types of high yielding securities or offshore securities (e.g. the global hybrid market counts 2,500 issues). However, some close their funds at $400-500 million and some do not allow major institutional inflow for fear of choking off the market.

INTRODUCTION

As the Australian bond market evolves away from government securities into credit, the hybrid market has begun to emerge. In July 2003, we concluded that the hybrid market at $14 billion was too small for institutions to invest in, because managers would have too much issuer concentration. In the meantime, the market has grown to $18-20 billion. Our estimate is that another A$5bn of unlisted hybrids exist. This compares with a market value of around $190 bln in the UBS Composite index.

Retail demand remains relatively strong, because of the perceived high yield and franking credits. Some managers have introduced Global Hybrid funds to offset the shortage in local supply. This report provides an update as to whether the market has become more suitable for institutions and also looks at present valuations.

DEFINITIONS

Characteristics
Hybrid securities combine both debt and equity characteristics, hence the name 'hybrid’. The term of investment is usually 5 years (the reset date), after which the investor can cash out, accept the new rates and term period or get the investment back in shares (at a slight discount). Most hybrids are subordinated (which means credit ratings of A-, BBB, or BB rated, if rated at all). A relatively high yield of 6-10% pa is usually associated with these subordinated structures.

Due to the limited size of the market, the demand has come mainly from retail investors. Wholesale investors have remained cautious, due to the inherent market concentration.

Types of Hybrids
There are two main types of hybrids:

1. Convertible notes.
The investor receives interest and can convert into underlying shares at a fixed ratio. From the company’s perspective, the regular cash payments are regarded as interest and classified as an operating expense.

2. Convertible preference shares.
The investor receives dividends. Companies like convertible preference shares because they can place them on their books as equity but have fixed payout or costs. For banks, they can be used as part of tier 1 capital. Furthermore, companies can use these to return excess franking credits. In terms of subordination, convertible notes rank above convertible shares.

Additional Clauses
1. Cumulative/Non-cumulative.
This refers to the event of missed dividend payments. In the case of Cumulative hybrids, missed dividend payments are added to the next dividend payment. In the case of Non-cumulative hybrids, missed dividend payments are forgone.

2. Redeemable/Non-redeemable. If the hybrid is redeemable, the holder has the option to sell the securities back to the company at the face value/ issue price at certain times. If it is deemed Nonredeemable the company is not offering to buy the securities back.

3. Exchangeable notes: A note that is convertible into the shares of a company other than the issuer of the debt instrument.

Reasons For Investing In Hybrids
A number of reasons attract investors to hybrids.

1. Stability of income.
Most securities are resettable. At the end of the reset period, the investor has the option of cashing out, receiving the underlying shares at, say, a 5% discount (for example, if a dollar conversion ratio is chosen, $100 of face value converts into $100 of shares – or $105 including the discount). Most Australian hybrids are structured this way, and are only minimally affected by the movements in the underlying share price. Unlike shares, the cash flows are known in advance and there is no capital fluctuation except in the event of default.

2. Exposure to underlying equities. If the investor opts for a hybrid with a fixed conversion ratio (e.g. 1 hybrid converts to 1 share) rather than a dollar conversion ratio, the investor participates in the upside, while being protected on the downside by the bond or floor value (i.e. the investor has the option to redeem at face value at the conversion point if this is preferable to converting to shares).

3. Tax advantages: convertible preference shares return dividends which can be franked.

4. High returns: Hybrids offer running yields higher than most other forms of fixed interest securities such as government bonds, bills or debentures (anywhere between 6-10% pa).

Market Composition
The full composition of the Australian hybrid market is shown in Appendix C. (see full text and appendices of this article in Best of Both Worlds? published as a separate resource to this feature)

• 55% comprises Reset Securities (Reset Preference Shares and Resettable Notes);
• 36% comprises Perpetual floating rate hybrids; and
• 9% comprises other securities.

In terms of risk, most RPSs have a duration of less than 1 year and a credit duration of between 2-3 years.

A full description of the risks that managers take can be found in Appendix A.

The income securities that were issued in the early part of the current decade are part of the Hybrid market as well, comprising around half of the perpetual floating rate notes, or 18% of the total market. They have a high credit duration (around 14 years) and are extremely sensitive to interest rates, as they do not offer the protection of a step up. We would consider these the most risky investments, though sophisticated investors readily take advantage of the inefficiencies in these markets.

Hybrid securities are not part of the UBS Composite Bond Index, and are less well researched than other bond sectors. Also, note that the market structure may not reflect the average hybrid manager portfolio structure. Some Hybrid managers, such as CSAM, only invest up to 25% in the domestic market, hence they can avoid illiquid issues, and selectively choose step ups and perpetuals.

Most managers have lowered liquidity risk by investing in overseas hybrids, high yield (which in general have a lower credit rating than the local hybrids), corporate bonds and syndicated loans.

As such, the general risk these managers take is quite low in terms of duration and credit duration as well as equity risk (as mentioned in Appendix A).

RECENT DEVELOPMENTS

The accounting treatment of hybrids changed from January 2005 when IAS (International Accounting Standard) 32 came into effect. IAS 32 states that if a hybrid has a mandatory redemption, it is to be classified as debt. Reset Preference Securities are now classified as debt, rather than equity (which means no more franking and banks can’t use these to strengthen tier 1 capital). In response to this new treatment, financial institutions (which account for the majority of hybrid issuance for their tier 1 capital) looked for new ways to satisfy both IAS and APRA.

Whereas RPS issues had maturities of three and five years, the financial institutions were required by APRA that in order for hybrids to classify as equity they needed to issue step ups. The step-up structure can push the maturity out to ten years (which is required for Tier 1 issues) and the investor gets compensated by an additional 100-200 basis points if the issuer decides not to redeem.

Since the second half of 2004, companies (especially financial institutions) have been issuing these longer dated step ups (known as perpetual non callable step up preference shares) to replace existing Reset Preference Shares. After the noncallable period (5 or 10 years) the issuer now decides whether to cash them out, convert them into equity at a discount or roll them into new reset terms. This has taken away control from the investor, as he/she can no longer choose to convert, hence step ups should be regarded as perpetual instruments. The investor’s only choice when wanting a return of capital is to exit the instrument through the secondary market.

For step ups, historically worldwide, the thinking has been that no company would want to pay up for the step up and hence, will choose to redeem. But in reality, conditions at the end of the term will dictate whether or not the company will convert. If spreads are tight at the point of issue (as they are now) and widen substantially, and the step up is low (e.g. 100 basis points), the company may have an incentive not to redeem, although its reputation (especially for a financial institution) with investors would be at stake.

PERFORMANCE

Correlation with Other Asset Classes

As mentioned before, most of the more recent hybrids issued are very 'bond like’ because issuers in most cases opted for the dollar conversion ratio, rather than the fixed conversion ratio. This lack of sensitivity with the underlying shares is referred to as a zero delta.

Historically, hybrids were structured in a way that led the securities to react to the underlying share price. A typical structure was:

1. A set dividend until conversion, where the conversion might occur on a number of dates.

2. They were usually issued at a similar price to the underlying share and converted at a set ratio, e.g. 1 hybrid converts into 1 underlying share. The fixed conversion ratio meant the price of these hybrids reacted to the movement in the underlying share price.

The old style hybrids typically had a delta between 0.2-0.5. In addition, some of these securities included minimum and maximum conversion terms, effectively giving the holder a put and call option if the share price reached a certain price. The new style hybrid has a delta close to zero.

The lack of correlation with share prices is shown in figure 1, below.

In fact, for the limited data period available, the hybrid index shows virtually zero correlation with bonds and a relatively low correlation with stocks, as shown in table 1 below. Admittedly, over this period stocks and bonds displayed a negative correlation which is not consistent with longer term outcomes.

One has to bear in mind that the market has limited history and may be skewed by a few issues. The $20 billion size of the hybrid market pales in comparison to the ASX 300 ($800 billion), the UBS Composite Bond ($190 billion) or the ASX 300 LPT index ($75 billion).

OVERSEAS HYBRIDS

History and Structure

Development
Overseas hybrids have a much longer history. The first issuance was in the US in the late 1800s by the US railroads. With shorter maturities and call protection the industry blossomed in the mid-1980s to early 1990s.

Market Size
At present the global convertible market is estimated at US$630 bn by Goldman Sachs as of Sept 04 with 2,250 bonds listed. This compares to a market size of A$20bn (US$15.4bn) and 60 issues in Australia.

Over half of the hybrids are rated investment grade. At one stage, following the Nikkei boom in the late-1980s, the Japanese convertible bond market was the largest globally, but a decline in bond values in that country and the new issuance of hybrids in the US and Europe has reduced the Japanese share of the total market. With the present low interest rates in Japan, few companies see advantage in issuing convertibles over straight debt.

In the US, convertible bonds are often used as a substitute for standard corporate bonds by lower rated, growing companies, especially in the high yield segment where a convertible can be used to lower interest rates. In Europe, the concept of exchangeables is popular. In an exchangeable, the instrument carries the equity risk of one entity and the credit risk of another, which makes it useful for corporate restructuring. The US continues to account for over half the new issuance, with the remainder split evenly between Europe and Asia.

Credit Quality
Hybrids are particularly attractive to new companies with limited credit ratings. Yet the overall quality of the global hybrid market is surprisingly good. In terms of credit quality, over 70% of convertibles in Europe are investment grade. This compares with 50% in Australia, which is similar to the US. Japan is an exception.

Following the equity market bubble of the late-1980s, many companies experienced financial distress and this led to convertibles becoming 'busted’ or rated as highly speculative.

The average credit rating of the universe is BBB (lower investment grade), based on the 300 bonds in the
Merrill Lynch Global 300 Convertible index as a proxy for the universe.

Available global convertible indices

• The UBS Global Convertible Index is the most widely followed index. UBS disaggregates the total universe into a number of regional sub-indices. It brings the global universe of 2,500 bonds and a market cap of US$640 bn down to 600 bonds, with a market cap of US$300 bn.
• The Merrill Lynch Global 300 Convertible index includes 300 of the most liquid convertibles, with a market cap of US$30 bn.

The Global Experience
We have undertaken analysis on the global convertible markets to see if the US results have been replicated globally. Global indices cover a shorter period, beginning January 1994. We used the UBS Global Convertible Index to represent the hybrid market, the MSCI World Free Index for equities and the Lehman Global Aggregate Index for fixed income. All indices were in US$. For the period from January 1994 to June 2005 we found results in terms of correlations and risk/ reward similar to those recorded in the US. The results are summarised in the tables below.

Downside Protection

Investing in convertibles would have resulted in a positive return for most years and avoided the major draw–downs, whereas global equity markets posted significant negative returns for at least three years. There are a few specific fundamental reasons why convertibles did not keep up with stocks over the last 6 months, which we will explain further on. As can be seen from the chart, it is a rare occurrence for convertibles to go down in price while stocks stay unchanged or go up. In short, the broad results experienced in the global hybrids market are consistent with the findings from the original Goldman Sachs/ Ibbotson study on the US market.

Similar to the US experience, global convertibles’ long-term performance has been highly correlated with large- and small-cap stocks, but much less correlated with the various fixed-income asset classes. This implies that convertibles will provide particularly effective diversification in fixed–income oriented portfolios. Depending on the preference of the investor, hybrids can be found which focus mainly on income (preferreds and busted convertibles), or give up yield in favour of higher equity participation. As a pure substitute for stocks, they have delivered similar returns over a 25 year time period in the US, or 11 years time period globally, with only 75% of the volatility.

Advantages and Disadvantages of Global versus Australian Hybrids

Advantages

• In contrast to Australian hybrids, global hybrids offer equity upside, which should lead to superior longer term performance, as equity can be expected to outperform debt in the long run.
• They have an asymmetric risk return profile. Australian hybrids move similar to high yielding bonds, hence offering a symmetric risk return profile. Australian hybrids’ price sensitivity is mainly related to changes in credit spreads. Hence, the risk/ return profile is symmetrical. Global convertibles, apart from spreads, also react to changes in stock price and volatility. The main benefit is that the bond acts as a floor, while the option value adds the asymmetric return profile.
• Global hybrids have a long history (reliable figures exist in relation to the US market since 1973) and a good track record.
• Global hybrid deals are more homogeneously structured than in Australia, where every deal is structured differently. Yet there is a wide variety of segments.
• Global hybrids provide good liquidity, with a market size of US$630 bn compared to A$20 bn (US$15.4 bn) for the Australian market.
• European hybrids offer superior credit ratings, most being investment grade (around 70%, with 20% not rated and 10% speculative grade).
• Valuations are more reasonable. There are specific reasons, such as the reduction in volatility, and the redemption of convertible arbitrage hedge funds that have led to lagging performance of convertibles versus shares over the past 6 months. It is very rare for convertible prices to go down while stock prices move up or stabilise.
• Furthermore, the hedging of the currency exposure can add an additional 2% pa for Australian investors based on current short term interest rate differentials.

Disadvantages

• A yield of RBA cash rate 1.5-2.0% pa (say 7.0- 7.5% pa) is achievable in the domestic market but this is not easily matched using a standard global hybrids manager. Even if we generously estimate a yield of 1.5-2% pa on the global hybrid index, this would lead to an income after currency hedging of 3.5-4% pa. In Australia, about 40% of hybrids pay franking credits, which leads to an additional 1% return per annum. Of course, straight comparison of running yields is problematical given the different composition of the markets (more bond-like in Australia, more equity-like globally). However, yield searching global hybrid managers can opt to add specific bond segments without intrinsic option value, e.g. busted convertibles, the US preferred markets or other forms of overseas high yield to increase the income component up to a value equal to their Australian counterparts.
• Interest rate risk is higher, e.g. in terms of interest rate sensitivity we estimate this at between 1.5- 2.5, versus 0.25-0.5 for the domestic market (which mainly invests in resettable preference shares). However, note that with the move to step ups, domestic credit duration is likely to increase.
• The global hybrid market is likely to be more efficient than the Australian hybrid market. Few global players bother with the Australian hybrid market. The emergence of the convertible arbitrage funds has led to increased demand for global hybrids, more efficient pricing and more volatility.

We find that overseas convertibles at this stage offer a more favourable risk reward profile to domestic convertibles, both in terms of long run returns (as there is more equity component inside) and also in terms of valuations. Depending on the preference of the investor, global hybrids can be found which focus mainly on income (preferreds and busted convertibles), or give up yield in favour of higher equity participation. There is less of a choice in Australia.

CONCLUSIONS AND RECOMMENDATIONS

Conclusions
The combination of a low interest rate environment, the increased presence of non traditional fixed securities, and the reduced value add from traditional duration and yield curve management, has led institutional investors to take on additional risk. Not only has equity exposure increased over the past ten years, but the demand for higher yielding fixed income securities has led to significant spread compression worldwide. In order to maintain meaningful yield levels, alternative income assets such as high yield, CDOs, infrastructure, alpha transfer products and hybrids are targeted. As the UBS composite bond index expanded its A- cut off to include BBB- grade bonds in the first quarter of 2005, the spectrum has widened.

The Australian Hybrid market can be characterised by a few trends. Firstly, the market is not yet mature, and has only recently outgrown its infant stage. Secondly, the market has been characterised by the prevalence of lower risk hybrids, such as Reset Preference Shares. However, these securities are now being replaced by longer dated Step-Ups. Thirdly, the franking credits do give investors 'the best of both worlds’, although most investors are willing to give up potential upside appreciation in return for capital stability and high yield. Since its inception in July 2001, the UBS Hybrid index has shown interesting risk/return characteristics for diversification purposes.

Recommendations

The domestic hybrid market
We remain cautious on the domestic hybrid market given the overall size, valuations and structural changes. We would not recommend a specific investment in local hybrid securities for institutional players until the market becomes broader and valuations are more reasonable. We have not rated many of the pure domestic managers because of the small size of the market. We may review a select number of managers as the market grows.

The global hybrid market
We find that the overseas hybrid market offers many more attractive options over the domestic market.
Although they give up the franking credit benefit, in return investors are rewarded with an asset class that has equity upside, a long history, is more homogeneous, and provides good liquidity and credit ratings. Historical research suggests an allocation to a global hybrid segment may have been of some value over the period.

Similar to the US experience, global convertibles’ long–term performance has been highly correlated with large- and small-cap stocks, but much less correlated with the various fixed-income asset classes. This implies that convertibles will provide particularly effective diversification in fixed-income-oriented portfolios. Depending on the preference of the investor, hybrids can be found which focus mainly on income (preferreds and busted convertibles), or give up yield in favour of higher equity participation.

Furthermore, global and US convertible studies spanning an 11 and 25 year time period respectively, show that hybrids have delivered similar returns to common stocks with only 75% of the volatility.

We find that overseas convertibles at this stage offer a more favourable risk reward profile to domestic convertibles, both in terms of long run returns (as there is more equity component inside) and also in terms of valuations. At present there are only a limited number of managers in Australia who offer some global convertible exposure.

Most managers in Australia tend to mix hybrids with other higher yielding asset classes, such as US high yield, syndicated loans and emerging market debt, so as to improve the income component, as their benchmark is the RBA Cash rate plus 2 or 3%, rather than any of the global convertible indices used by the offshore managers.

General conclusions
Hybrids can provide a useful risk/return outcome (that is, sharing of some equity returns on the upside, some protection on the downside). This is aligned with what many investors seek, thus, in principle incorporation of some hybrids exposure in a broader multi-sector portfolio makes some sense.

In conclusion, we believe that any investors who do wish to participate in the hybrid market should invest with managers who can diversify across a range of higher yielding fixed income investments and who can also invest globally (and into global hybrids), rather than look solely at the domestic hybrid market.

© 2005, Mercer Investment Consulting
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