Hybrids misfire

PORTFOLIO POINT: Investors looking at hybrid securities should be aware of the inherent risks, with returns having slumped as credit spreads have widened.

Over the last six months, over $6.5 billion of listed debt securities (including hybrids) have been issued and listed on the ASX.

The performance of these new issues has been poor, with credit spreads widening by up to 59 basis points. The one notable exception and the star performer of the market, the Woolworths hybrid issue, has experienced a strong credit spread rally of 93bps.

In these same six months, we have seen great volatility in the market, reflecting the uncertain situation in Europe and a slowing China that has resulted in poor equity market performance. But how do we assess the performance of these securities over the same timeframe? One way is to compare credit spreads of the issues against the Australian iTraxx. The Aussie iTraxx is a “proxy” for credit spreads (the amount investors require to invest in credit risk securities) in the Australian market. It is an index, not unlike the ASX All Ordinaries Index for equities.

The iTraxx is composed of five-year credit default swaps (CDS) for the 25 most liquid and highly traded investment-grade Australian entities in the market and is an important tool in assessing the movement and trends in credit spreads for the broader market. Each of the 25 entities is given an equal weighting. CDS can be traded in their own right, but are really only for wholesale investors with minimum trades of $10 million.

Importantly, the iTraxx does not incorporate outright yields; that is, the movement in base interest rates such as the government bond risk-free rate, the RBA cash rate or the bank bill swap rate (BBSW). The Aussie iTraxx only looks at the credit spread component that is overlaid or added to the base interest rates or yield curve.

Figure 1

Figure 1 shows the Aussie iTraxx performance, which indicates that market perceptions of risk are increasing and wholesale investors are requiring greater spreads, given increasing uncertainty.

For listed hybrids, the spreads for the majority have barely changed when compared to the iTraxx, which increased by 57bps for the three months from March 1 until May 31, 2012.

Investors generally are seeking defensive assets and we don’t consider listed retail hybrids to be defensive, because even though they are in most cases lower risk than equities issued by the same issuer (while providing higher yields), they tend to show similar levels of volatility as the underlying equities in stressed conditions. If, as an investor, you were forced to sell in a stressed market, there’s a strong possibility that you would be forced to accept a loss.

The recent batch of hybrids have underperformed with poor returns since their issue dates, however given the blow-out in the ITraxx, I actually would have expected most of the hybrids to have underperformed by greater margins. To my mind, it just shows the disconnect between the retail and the wholesale markets. I expect the credit spreads on hybrids to catch up to the recent moves in the iTraxx and this does not bode well for hybrid prices in the near future.

Of the hybrids to be issued this year, only the Woolworths hybrid issue (WOWHC) has outperformed with a total return since its November debut last year of 7.62%.

Table 1 below shows the total return, which is equal to the capital gain/loss plus any distributions including franking for each security since the issue date.

The following observations can be made on performance over the last six months of trading:

• The majority of securities have flat-to-negative total returns since issue.
• This poor price performance is reflected in the widening of trading margins – a measure of the credit spread currently required by investors to hold these securities to maturity or call date.
• Credit spreads have widened between 13 to 59bps since issue.
• Insurance Group Australia’s issue IAGPC has been the worst performer, losing 1.75% since it was issued on March 23.
• Woolworths is the exception, where the credit spread has tightened by 93bps to 232bps from an issue margin of 325bps.
• When the last coupon was paid (or the time lapse until the next coupon is due) is important in assessing the hybrid’s performance. Just like shares, you’d expect the price of the hybrid to increase up until the coupon is paid, then decline afterwards.

A couple of other factors come into play when assessing performance:

• The first to the market with a new or unique issue or a high margin will usually do better because of scarcity. The Woolworths hybrid was issued by a strong investment-grade company with a stable, low-risk business (despite the funds being raised for a new higher-risk retail venture) and there have been few high-quality corporate issuers. Also, this is Woolworths' third issue and the consistency of how management have treated and repaid past issues has contributed to this issue’s success. This issue satisfied investors’ appetite, in terms of risk, reward, scarcity and the opportunity to diversify away from financials.
• Possible investor fatigue, especially given the high volume of issuance from the banks.
• Similar deals to those previously issued don’t seem to get as much attention.
• If there’s high demand, the financial institutions, in particular, upsize the deal.
• The banks issuing hybrids have the additional benefit of regulatory oversight by APRA and are regular issuers, meaning they need to preserve their reputations to enable that reissuance. In contrast, the corporate issuers that haven’t been regular issuers don’t have reputations to protect, nor APRA oversight.

Table 1. Recently listed hybrids

Elizabeth Moran is director of education and fixed income research at FIIG Securities.