An investor's guide to hybrid securities
For investors, hybrids promise regular interest payments at rates usually several percentage points higher than those paid on bank term deposits or ‘vanilla’ corporate bonds; while the potential equity convertibility is a more conservative way of holding exposure to a company.
In the wider context of the ASX listed interest-bearing securities market, hybrids are, for many income-oriented investors, an integral part of a diversified portfolio, and a useful tool – and they are expected to remain so.
These days, the term ‘hybrids’ effectively covers any interest-bearing security that has both debt-like and equity-like features embedded in it. Some hybrids (like those issued by the banks) take this dual nature all the way to the possibility of conversion into the ordinary shares: others (like some corporate hybrids) only have equity-style features, such as the ability to defer interest payments without triggering a default.
Repayment of the investor’s principal can be in the form of cash or ordinary shares of the issuer. Although they are part of the Australian Securities Exchange’s (ASX’s) listed interest-bearing security – or listed credit – sector, the hybrids are a discrete group of investments because of their equity-like features.
Hybrid securities’ distributions (or dividends) can be franked or unfranked. They are typically unsecured, ranking just above ordinary equity. Hybrids are technically perpetual securities, meaning that they may never be redeemed, and an investor may never have their invested capital returned.
Hybrid securities typically offer higher interest returns than those paid on bank term deposits or ‘vanilla’ corporate bonds. The returns are usually ‘floating-rate,’ being set at a margin over the prevailing bank bill swaps reference rate (BBSW) – whether for the 90-day or 180-day rate – which is typically used as the risk-free base rate in the pricing of many securities. (BBSW is a compilation of observed market rates traded among Australian Financial Markets Association (AFMA) “prime” banks – namely, Commonwealth Bank of Australia Limited, ANZ Banking Group Limited, National Australia Bank Limited and Westpac Banking Corporation Limited – updated daily (at 10:10 am) by AFMA.)
Key features of a hybrid
- When a hybrid is issued, investors know the following:
- the face value – the price at which the security is issued and the amount the investor will receive at maturity/redemption by the issuer;
- the coupon – the distribution/dividend return investors receive each year for holding the security, paid either quarterly or semi-annually;
- the maturity/redemption date – the date at which holders will be repaid the face value of the security in cash; and
- the conversion date – the date when a preference share or other convertible security will convert into ordinary shares in the issuer (assuming the required conversion conditions are met).
- At any time after issue, a listed hybrid will have:
- a cash running yield – the expected annual amount of distribution given by the margin over BBSW, divided by the last traded price of the security;
- a gross running yield – the cash running yield including any attached franking credits;
- a yield to call/maturity – the expected annual return that will be achieved by buying the security at the last traded price and holding it to the maturity/conversion/call date. The return is made up of the security returning to its face value, plus forecast distributions/coupons, and franking credits if applicable; and
- a trading margin – the yield to call/maturity, minus the prevailing swap rate. This shows the return premium investors currently receive in the security, compared to holding bank bills.
Like any investment, hybrids are issued to meet the particular needs of issuers; and bought to meet the particular needs of investors. Companies issue hybrids to raise capital, but why they use hybrids for this purpose at any time could be driven by a number of factors.
Firstly, a hybrid issue can offer the issuer capital efficiency, from a regulatory or balance-sheet perspective, compared to other forms of funding.
For example, a bank (or insurance company) issuer will be mainly concerned with structuring a hybrid issue to achieve qualification as a particular form of “regulatory capital,” under prudential standards set globally by the Basel Committee on Banking Supervision – a committee of banking supervisory authorities based at the Bank for International Settlements (BIS) in Basel, Switzerland – and administered in Australia by the Australian Prudential Regulation Authority (APRA).
A corporate issuer does not have these regulatory requirements: its main concern will be to structure an issue so as to achieve a particular outcome for accounting and tax purposes. It may be seeking to have the issue qualify for “equity credit” from ratings agencies, and count as equity in the evaluation of the company’s credit rating, yet represent cheaper funding than ordinary equity – while maintaining Australian Taxation Office (ATO) classification as debt, which means the interest payments are tax-deductible. An additional attraction is that a hybrids issue does not dilute ordinary shareholders’ holdings.
Hybrids are an important tool for major corporate issuers in their capital management strategy. Hybrid issues can represent a good use of the company’s
stash of franking credits: because retail investors like these, it allows the issuer to offer a lower distribution rate than would otherwise have been necessary.
Hybrids offer issuers funding diversification away from banks and wholesale investors – with hybrids they can tap the retail investor market, particularly the growing self-managed super fund (SMSF) investor pool, which is a strong source of demand for income-generating investments.
Hybrids can also be a viable alternative for a company raising money for an acquisition: instead of taking on more debt or issuing equity, they can raise funds without affecting their credit rating or diluting shareholders’ equity.