How our hybrids beat the index

PORTFOLIO POINT: The uncertain outlook for the stockmarket means our three model portfolios are likely to outperform again.

Last year I wrote a feature that looked growing likelihood that shares were about to enter a period of underperformance, and constructed three portfolios of hybrid securities that were designed to hedge against this possibility (click here).

The model portfolios were designed with an eye to risk and were characterised as lower-risk, medium risk, and medium/high-risk. I’m pleased to report that all three of the portfolios outperformed the benchmark ASX 200 Accumulation Index by margins of between 4.6% and 11.1%.

Investors who are not familiar with hybrid securities, which rank ahead of equity but behind debt in the event the business is wound up, should read our previous column that more fully explains their merits and shortcomings (click here).

The rest of us might use this moment to consider the outlook for investors and consider the reasons why equities might prove to be a disappointment for investors two years running, which in my opinion extends to:

• Issues concerning the outlook for growth and inflation in China.
• European sovereign debt issues in several member countries.
• Austerity measures that produce higher unemployment across Europe.
• US debt and deficit issues as well as stubbornly high unemployment.
• The dramatic shock to Japan caused by its earthquake and tsunami.

Based on previous debt repayment cycles, it is likely that the global economy will continue to experience lower growth levels than it has over the past decade, and because of this we think it likely that the stockmarket will continue to underperform over the coming 12 months.

Given this outlook, it may well be appropriate to revisit our hybrid portfolio structures and consider what they should look like for the next 12 months. But first, let’s look how the individual portfolios performed.

-The portfolios vs the market
	ASX	Risk *
Low-risk hybrids portfolio
National Bank Income Notes	NABHA	Low
Commonwealth Bank PEARL III	PCAPA	Low
Woolworths Limited Income Notes	WOWHB	Very low
Total return (12 months to July 25, 2011)		10.60%
Volatility		4.00%
X
Moderate-risk hybrids portfolio
Australand Trust Preference share	AAZPB	Medium to high
National Bank Income Notes	NABHA	Low
Commonwealth Bank PEARL III	PCAPA	Low
Total return (12 months to July 25, 2011)		14.40%
Volatility		5.10%
X
Moderate/high risk hybrids portfolio
Australand Trust Preference Share	AAZPB	Medium to high
National Bank Income Notes	NABHA	Low
Multiplex Trust Preference Share	MXUPA	High
Total return (12 months to July 25, 2011)		17.10%
Volatility		6.50%
X
ASX 200 Accumulation Index
Total return (12 months to July 25, 2011)		6.00%
Volatility		12.80%
X
All Ordinaries Accumulation Index
Total return (12 months to July 25, 2011)		7.10%
Volatility		12.40%
* One year historical volatilities for the hybrids were calculated and used to set these parameters.
Source: Calculated based on data from IRESS

As you can see from the evidence above, it is quite clear that investing in hybrids has paid off handsomely in terms of both return and volatility for investors who used our models to construct portfolios of equal weighting.

For example, even investing in the low-risk hybrids with equal weights has provided a total return of 10.6% over the 12 months to July 25, 2011, and with an extremely low volatility of 4.0%. This implies that it has outperformed the equity market by about 4.6% compared to the ASX 200 Accumulation Index. More importantly, it has volatility that is about a third that the equity market.

For the moderate and moderate high risk hybrid portfolios, the outperformance over the equity market was more than 7% and 10.0% respectively with half the volatility of equity market in general. We believe these are outstanding performances and the total returns are well illustrated by the chart below.

So what about going forward?

As I have already noted, I continue to be cautious of the global economic outlook. Thus I believe it is prudent to continue to allocate funds into lower-volatility high-yield hybrids as part of any equity portfolio, but there are some minor changes to be incorporated.

Separately, for investors with a greater tolerance for risk we have created an even higher-risk model portfolio. To mitigate some of these higher-risk hybrids, we modulate the volatility of the portfolio by introducing two more medium-risk hybrid securities so that there are five hybrids in this new higher-risk portfolio. We have tabulated them in the table at the bottom of the page. Note the changes.

While we do not expect a re-run of the high total return of the past 12 months, we expect a total return at around the average running yield for each portfolio. This suggests returns of about 7% (plus or minus 1%), 8.5% (plus or minus 1%) and 10% (plus or minus 1%) for the low, medium and medium/high risk hybrid portfolios respectively over the next 12 months, with similar volatility of low 4% to high 6% annualised volatility.

For the new higher-risk hybrid portfolio, we expanded the number of securities held to five to allow for deeper diversification. We have introduced two new higher yielding hybrid securities; being Goodman Plus (GMPPA) and Nufarm Step Ups (NFNG) which we have provided a brief overview of below.

For this higher-risk hybrid portfolio, we expect total return of around 12% (plus or minus 1%) with a much higher volatility of 8–10%, albeit still a lower potential volatility to what the equity market is offering.

GMPPA

This is known as Goodman Plus, a preference share of Goodman Group Limited (GMG). GMPPA has a face value of $100 and the distribution is based on 1.90% over the 90-day BBSW. At the current price, it is yielding about 9%. However, in March 2013 there is a call back (redemption) or a one off a step up of 1% pa, which is less than 20 months away. We believe it is unlikely that they will redeem and a step up is more likely. This implies that the running yield post step up would be more than 10.3%. We believe this is an attractive yield for GMPPA. Goodman Group Limited also enjoyed strong support during and post GFC by the Canadian Pension Fund Investment Board and the Chinese investment Corporation.

NFNG

NFNG is the step-up hybrid of Nufarm Limited (ASX:NUF). It also has a face value of $100 and currently the distribution is based on 1.90% over the 180-day BBSW. The distribution is payable semi-annually and at current price and rates it is yielding about 9.3%. However, you will note that there is a step-up on November 2011, which is only a few months away. Alternatively, they can redeem and reissue. It is our view that they will step up so that the running yield would rise to about 12.3% pa by November this year. We believe that a step up will lead to a capital appreciation from holding these notes in the next three to 12 months. Further, we also note that there is a clause in the NFNG product disclosure statement that if Nufarm is taken over, the predator is required to redeem the NFNG. We note that Sumitomo Group owns about 25% of Nufarm Limited and has been rumoured to intend acquiring it eventually.

-The four hybrid portfolios
	Price (26/7)	Margin	Running yield	Yield	Dist	Risk	Relative value	Call / step up / reset date
Low-risk
NABHA	80.4	1.25%	7.72%	8.26%	quarterly	Low	Discount	Perpetual
PCAPA	186	1.10%	6.49%	8.13%	quarterly	Low	Premium	1% step up in April 2016 or call back
WOWHB	100.32	1.05%	6.09%	10.31%	quarterly	Very low	Fair	Call date September 2011 or 2% step up
Average			6.76%	8.90%
x
Medium-risk
AAZPB	90.5	4.80%	10.82%	10.98%	quarterly	Medium	Slight discount	Perpetual
NABHA	80.4	1.25%	7.72%	8.26%	quarterly	low	Discount	Perpetual
PCAPA	186	1.05%	6.49%	8.13%	quarterly	low	Premium	Call date in April 2016 or 1% step up
Average			8.34%	9.12%
x
Medium/high
AAZPB	90.5	4.80%	10.82%	10.98%	quarterly	Medium	Slight discount	Perpetual
MXUPA	79.5	3.90%	11.24%	11.73%	quarterly	Medium high	Slight discount	Perpetual
NABHA	80.4	1.25%	7.72%	8.26%	quarterly	Low	Discount	Perpetual
Average			9.93%	10.32%
x
Higher risk
AAZPB	90.5	4.80%	10.82%	10.98%	quarterly	Medium	Slight discount	Perpetual
GMPPA	78.5	1.90%	8.83%	25.26%	quarterly	Medium high	Discount	Call date March 2013 or 1% step-up
NABHA	80.4	1.25%	7.72%	8.26%	quarterly	Low	Discount	Perpetual
MXUPA	79.5	1.90%	11.24%	11.73%	quarterly	Medium high	Slight discount	Perpetual
NFNG	76	1.90%	9.31%	158.21%	semi- annually	High	Fair	Call date November 2011 or 2% step up
Average			9.58%	42.89%

NB: For the perpetual hybrids, a time frame of 40 years is utilised to calculate the yield to call. In other words, we assume that they will be called back in 40 years which is a very long time.

Relative value is based our analytical model of valuing hybrids. It is based on a similar equity multiple valuation approach used in MyClime for valuing stocks.
Small discount (or premium) ~±2.5%
Fair ~±1.0%
Discount (or premium) ~ ±2.5% to ± 5.0%
Big discount (or big premium) ~ ±5.0% to ±10.0%
Very big discount (or very big premium) ~<±10.0%

Vincent Chin is a senior analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). Using MyClime, our asset portfolio is ranked the #1 Best Performing Fund by Morningstar – Equity Australia Large Cap, 30 June 2011. For a free two-week membership, click here.