|Summary: Australia’s major banks have been at the forefront of the hybrid securities market, and still dominate in terms of total issuance. Offering high long-term yields, hybrids have the characteristics of other fixed income securities such as bonds. But they can be converted to the issuer’s shares under certain circumstances, and payments can be deferred at the issuer’s discretion. Investors should be aware of their inherent risks.|
|Key take-out: The Australian Securities and Investments Commission has issued many warnings about investing in hybrids that offer equity-like risks for debt-like returns. But investing in bank hybrids, when the price is right, can provide a reasonable income and some degree of capital stability.|
|Key beneficiaries: General investors. Category: Fixed interest.|
What are hybrids?
Hybrids are listed fixed interest-like securities that are available to investors who want to explore opportunities outside listed ordinary shares. The listing of the Commonwealth PERLS in 2001 was the first major bank back hybrid, which gained a lot of investor interest.
Currently there are 31 hybrids listed on the Australian sharemarket, which are structured as either income securities, perpetual step-up securities or reset convertible preference shares/notes (see Table 1 for features). These include 15 issued by the big four banks, four by regional banks and 13 by corporates.
Low interest rates have supported demand for higher-yielding, fixed interest-like securities as investors are seeking more attractive yields outside of term deposits and cash deposits. Hybrid securities can provide another source of income and return that is similar to a fixed interest security but with some characteristics of shares.
The strong performance of the banking sector relative to the broader market has been supported by investors looking for higher yields from dividends, with the added benefit of franking. The long-term volatility of bank shares is higher than the volatility of the overall sharemarket – 18% versus 13% – while the volatility of hybrids is lower than the broader sharemarket.
Banking shares have outperformed the broad market particularly well since 2008, due to the relatively stronger franked dividends in a low-yield environment. On the back of this, hybrids issued by the major banks also have performed very well, with the expectation they will provide a franked yield that is higher than the market average but with lower volatility than shares – although during the GFC, we did see share-like performance by hybrids.
Hybrids: alternative yield to bank shares but can trade like shares
Shares are usually four times more volatile than bonds and double the volatility of hybrid securities listed on the sharemarket (see the volatility of hybrids versus shares in Figure 1). Volatility in sharemarkets recently has been low by historical standards, but this can pick up if any uncertainties arise with respect to economic conditions, global concerns or other significant market events. Increased volatility would lead to increased volatility for hybrids, but generally less than the broad sharemarket, depending on whether there was another “GFC-like” event.
Since 2011 there has been issuance of $28 billion in hybrids, primarily driven by the banks, which investors have sought as an alternative investment option to bank shares. The banks are required to meet new capital requirements and the hybrids are structured to do this. Because the hybrids can be quite long-dated, it is important that the issuer has the required financial health to support these securities, although by itself this does not guarantee payment of dividends.
There is a new style of hybrids being offered (see Elizabeth Moran’s article “Higher-risk hybrids on the rise” that often have longer terms until first call/maturity and many options for possible repayment, which need to be evaluated by the investor. Some of these options could include conversion to shares, usually in a time of stress, which would most likely result in a large loss due to the share price falling. Or the securities can become perpetual, which means the repayment of principal does not take place and the only way to get your money back is to sell on the sharemarket – which may result in a loss.
Benefits of investing in hybrids
Hybrids can offer some benefits that set them apart, such as:
- Higher yields compared to term deposits, and that may also be higher than the underlying issuer’s shares.
- Liquidity. In the event that the investor requires the return of principal, hybrids can be sold on the sharemarket.
- Regular income paid semi-annually or quarterly, which will change with movements in interest rates for floating-rate securities.
- Potential tax benefits due to the franking – although this is usually quoted in the pricing as opposed to franked dividends from ordinary shares that are quoted before franking.
- Ranks above ordinary shares in the event of a company wind-up.
- Prices tend to be less volatile than underlying shares.
Risks of investing in hybrids
But there are risks that need to be considered:
- Can convert into shares if the non-viability clause is triggered – in the event that the Australian Prudential Regulatory Authority (APRA) believes it is necessary to boost capital, liquidity or due to an unsustainable increase in non-performing loans – and the shares may be worth less than the face value or the original price paid.
- Hybrids are typically junior ranking debt, so they rank just above equity and rank below other forms of debt (see Figure 2),
- Can trade at a discount to the face value based on company specific risks or general market conditions.
- Liquidity issues can impact prices in the listed market.
- Credit rating agency changes can impact prices.
- Payment of interest may be deferred at the issuer’s discretion and is often non-cumulative – but often any deferral will also impact share dividends paid by the issuer.
Is there any value left in hybrids?
Comparing the hybrids issued by the major banks, due to strong performance on the back of high demand for these higher-yielding securities, the attractiveness of hybrids as an alternative to bank shares’ franked yields has fallen.
The inclusion of the non-viability clause is also something to be aware of, as this can result in investors holding shares when the sharemarket is collapsing. At these times, a fixed interest product offering lower volatility is a much better alternative. This could have been the situation in 2007, in the case of National Australia Bank’s Tier 1 capital being close to the required lower limit of 5.125%. It is now above 8%, but if it fell back close to those lower levels APRA could force the conversion of its hybrids into shares to supports its capital base .
Although the financial viability of the underlying issuer is important when investing in hybrids, a well-known name or brand does not remove the risks associated with investing due to the inherent terms of that particular security. Other factors of importance are the yield to maturity/redemption, the price relative to historical price, and the trading margin.
The yield to maturity/redemption is an important tool for comparison. It is the actual return on an investment if held to maturity, by taking into account the interest payments received, face value, and the capital discount or premium paid for the securities at the time of purchase.
The trading margin also allows the comparison of similar securities by the spread of the yield to maturity over the Bank Bill Swap Rate, applicable to the time to maturity of the security.
The inclusion of hybrids in a portfolio is often due to their fixed interest-like characteristics, without discourse to the possibility of them trading as the underlying shares. Although hybrids can be less volatile than the underlying shares, and while paying a regular attractive income stream – they are called hybrids for a reason. This means they sit between shares and fixed interest with respect to their returns, and very close to shares with respect to their place in the capital structure. Hybrids do not have the defensive characteristics of bonds.
The higher yield offered by hybrids can be enticing, but investors should be wary of the quite complex conditions attached to them, which can differ between issues.
Investors need to familiarise themselves as much as possible with the following characteristics before investing:
- The credit risk of the underlying issuer (investment grade is superior).
- Where the securities sit in the capital structure with respect to receiving any return of the face value in the event of a default (usually just above ordinary shares).
- A fixed maturity date (as opposed to perpetual).
- Whether payment of dividends is discretionary and non-cumulative (a common characteristic and hard to avoid, although a dividend stop in place prevents the underlying issuer paying dividends to ordinary shareholders if obligations to hybrid holders are not met first).
The Australian Securities and Investments Commission has issued many warnings about investing in hybrids that offer equity-like risks for debt-like returns. But if one is aware of the risks then investing in bank hybrids, when the price is right, can provide a reasonable income and some degree of capital stability.
Table 2. Big four banks' Hybrids
|ASX Code||Name||Issuer||Last Price||Current Yield||YTM|
|ANZPB||ANZ Float 06/16/14||AUST & NZ BANKING GROUP||99.80||5.16%||5.24%|
|ANZPC||ANZ Float 09/01/19||AUST & NZ BANKING GROUP||102.50||5.60%||5.85%|
|ANZPA||ANZ Float 12/15/16||AUST & NZ BANKING GROUP||101.66||5.65%||5.83%|
|ANZPE||ANZ Float 12/31/49||AUST & NZ BANKING GROUP||102.81||5.82%||6.01%|
|ANZPD||ANZ Float 12/31/49||AUST & NZ BANKING GROUP||103.68||5.82%||6.16%|
|CBAPC||CBAAU Float 12/31/49||COMMONWEALTH BANK AUST||105.74||6.10%||6.55%|
|CBAPA||CBAAU Float 12/31/49||COMMONWEALTH BANK AUST||203.20||5.98%||6.15%|
|NABPA||NAB Float 03/22/21||NATIONAL AUSTRALIA BANK||102.12||5.76%||5.94%|
|NABPB||NAB Float 12/31/49||NATIONAL AUSTRALIA BANK||101.80||5.79%||5.99%|
|WBCPD||WSTP Float 03/08/21||WESTPAC BANKING CORP||102.16||5.72%||5.94%|
|WCTPA||WSTP Float 06/30/16||WESTPAC TPS TRUST||96.70||3.78%||3.74%|
|WBCPB||WSTP Float 09/30/14||WESTPAC BANKING CORP||101.54||6.36%||6.54%|
|WBCPC||WSTP Float 12/31/49||WESTPAC BANKING CORP||102.84||5.81%||6.01%|
|Source: Bloomberg data as at 4 June 2014|