GOTCHA! Too safe to be true?

Don't be fooled by the latest offering from the banks - hybrids promise much but in reality offer high risk for low returns, writes David Potts.

Don't be fooled by the latest offering from the banks - hybrids promise much but in reality offer high risk for low returns, writes David Potts.

Banks are dangling yields of 7 per cent to 8 per cent in front of investors desperate for safety - but they come laden with booby-traps, such as not quite paying when they say, or being as safe as you might think.

Known as hybrids because they're part shares and part bonds, the latest offers are far from a safe halfway house. They're pseudo-shares - all risk for less return.

On offer are the Commonwealth Bank's PERLS at 7.4 per cent, Suncorp's 8 per cent and Bendigo and Adelaide Bank's 8.4 per cent.

These rates are floating but are so far above anything else, it shouldn't matter if the Reserve Bank cuts again. They're also franked, which is the first trap because the 30 per cent tax break is already built into the yield, unlike on a share.

So for 7 per cent you get 4.9 per cent spread over four instalments (or two in Bendigo's case), with the other 2.1 per cent a cheque in the mail from the Australian Tax Office, possibly a year later if you please.

But wait, there's worse.

The hybrids have been designed to be "crash dummies", in the words of the head of listed securities at Centric Wealth, Hugh Dive.

Under new international banking regulations, they're designed to be the first to fold in any future crisis.

Does that sound safe to you? No, me neither.

A BETTER OPTION

A safer halfway house than a hybrid would be a mix of shares and bonds, Dive says.

After all, if regulators consider hybrids to be pseudo-shares, why not buy the real thing and get a better yield without the franking sleight of hand?

CBA shares are yielding 6 per cent - which is 8.6 per cent fully franked. The answer is that shares are at the bottom of the credit pole, and hybrids one notch up.

But there's not much in it. As the GFC showed, hybrid prices can crash in tandem with the mother stock.

On average, hybrids have traded 3.7 percentage points above the official cash rate and shares 4.5 points, according to Dive. So shares are only 22 per cent riskier.

The gap is narrowing. "The new hybrids are closer to equity and have a lot more conditions," he says.

That the yield on CBA shares is a good percentage point higher than its hybrid is more than enough compensation for the slightly higher risk, he says.

"The shares are absolutely better value," Dive says. "The income is much better and they can grow over time. The banks are also likely to lift their dividend payout ratios in the next year or two."

Perhaps more telling is that the smart money avoids hybrids.

"There's a big part of the investment market that wouldn't buy them," Emma Jenkin, a fixed-income analyst with FIIG Securities, says.

And it's not as if you'll get your money back they convert to shares, though a few extra are thrown in.

That's another trap.

There's a mandatory conversion date which, it transpires, isn't necessarily mandatory at all.

"An expectation that at the end of a set period an issuer will definitely redeem the hybrid so that investors get repaid in full is very dangerous," ASIC commissioner John Price says.

PORT IN A STORM

So, what's safe? Term deposits, because they're government- guaranteed. But even they have a subtle trap: they can't provide for your retirement once tax and inflation take their toll.

The same goes for bank bonds traded on the stock exchange, such as the Commonwealth's CBAHA.

With a 5 per cent floating yield, it starts behind anyway and doesn't have a government guarantee.

Similar offerings from the other big banks - but called subordinated notes - go up to just more than 6 per cent in the case of Westpac's.

Mind you, these could all come into their own one day when rates rise again.

One of the few listed fixed-rate bank bonds is offered by Heritage Bank (HBSHB), which yields about 6.5 per cent for five years.

Again it's riskier than a term deposit, though not bad value if you think rates will fall further.

Government bonds might be safe but they're expensive, considering you'll get only 4 per cent if you're lucky. Even they're booby-trapped. There's a global bond bubble of record low yields that will burst at some point.

"German bonds for 10 years are at a 495-year low," says Kate Howitt, the portfolio manager of Fidelity's Australian Opportunities Fund.

"And it's at least a 200-year low in the US.

"Is the highest price in 495 years a good investment?"

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