Hybrids perversion

Some of the recent long-dated hybrids issues prove capital markets are lacking integrity.

PORTFOLIO POINT: Retail investors are being duped big-time with some of the latest hybrid issues. Regulatory action is needed to restore markets integrity.

With $8 billion of hybrid securities having been issued since January 1 on the Australian listed securities market, it could hardly be claimed that a warning this week regarding such issues by the Australian Securities and Investments Commission was prescient.

Certainly the warnings were relevant and useful for retail investors; but they are a little late!

As one financial paper reported this week:

“The Securities watchdog has stepped up warnings over hybrid-share issues, saying investors can sometimes be lured into ‘complex’ and ‘dangerous’ instruments by companies that are trusted household names ... consumers should consider whether hybrids are suitable for them and seek unbiased financial advice on the notes. The Commission also said companies needed to provide clearer disclosure about the risks behind products when marketing them to investors.”

Readers will note that my income portfolio contains a mixture of listed debt securities, perpetual hybrid securities and high-yielding equities. The portfolio is designed to spread risk, generate a high recurrent yield and potentially deliver some capital gain.

In creating this portfolio I have rarely been attracted to some of the recent long-dated hybrid/debt issues. I have, however, tended to like the recent listed debt securities issued by the large banks and Woolworths. Notably these large debt issues were priced by the institutional or wholesale market. They were priced by professional fund or debt managers, who have well established risk and structuring rules for such issues.

Large sums raised from and negotiated with large investors will generally ensure that the agreed terms are fair for retail investors. Indeed the investment banks who sit between the issuer and the institution will need to ensure that both parties are treated fairly, for they risk affecting relationships and long-term revenue if they don’t.

However, when an issuing company structures an issue squarely designed to attract retail investors and enlists highly commissioned sales agents to distribute them – the that is a recipe for problems! Then with an investment bank or advisor solely employed by the issuer to get the best possible terms from retail investors, there is no appropriate checking or balancing process.

As a consequence you can predict that there will be problems in some of these very long-dated securities, when unsuspecting investors are forced to dig up the original issuing documents to find out why they have not been paid interest or redeemed in a reasonable period.

So there lies the rub. Who is actually negotiating on behalf of retail investors when the terms of a hybrid/debt issue are structured? Is independence challenged when advisors are paid or offered a fee or commission to distribute such a security? Are the terms of some of these issues deliberately made so convoluted and unclear that a reasonable person would struggle to understand or assess the inherent risks of these investments? Further, when a company deliberately avoids its own shareholders and directly offers a raising to non-shareholders – then what does this suggest about the issue?

It is my view that the recent surge in inappropriately long-dated hybrid issuance is a continuance of the perversion of capital and debt markets that has developed over the last decade.

Many will claim that capital markets have continually become more sophisticated, and therefore markets efficiently price risk through (for instance) the computerisation of trading which drives liquidity. However, this argument mistakenly relates liquidity to risk.

For instance, if liquidity was relevant to risk then why did the huge bond market of Europe consistently from 2001 to 2008 misprice the risk of default by Greece? Why did Greek bond issuance balloon to over €400 billion with massive fiscal deficits, and yet these bonds continued to trade at a small margin above those issued by the industrial juggernaut of Germany? There is plenty of fiscal evidence to suggest that Greece was just as insolvent in 2006 as it was in 2009, when markets suddenly acknowledged the risk of default. Liquidity was never a relevant issue.

So what should be done?

Much of what I regard as the solution resides around the notion of integrity. Unfortunately integrity cannot be forced by regulation. Rather, it is something that must be embedded over time in a society through leadership, parenting, encouragement and education. Whilst integrity cannot be forced by surveillance, it certainly can be enforced by swift indictment, trial and penalty. A society should have no patience with those in a fiduciary position that lack integrity. Further, the law should be clear that the breaching of integrity is a serious offence.

Unfortunately the notion of integrity is continually challenged by the practitioners of legal advice. For instance, we can see today that the long-established notion of “buyer beware” is used increasingly to help justify the behaviour of an individual or a company that lacks integrity. Further, the legal notion of fiduciary duty has become so debauched that many avoid this duty and their inherent conflicts by seeking clever legal advice. Regulation fails because it generates a roadmap by which a paper trail can be used to create a perception of proper process.

The solution will evolve when there is a general and unrelenting acceptance that we have created a capital market that lacks integrity. Whilst markets have continued to develop in recent years, much of this evolution has been generated by the pursuit of greed.

So investors must challenge our governments and our administrators to stop the senseless extension of markets. High-frequency trading is just one perverse result and another is the creation of hybrid debt securities that are simply unfair to investors.

Thus, whilst we wait for integrity to fully re-emerge into both our society and our markets, we should insist that our regulators advise the government that certain types and certain terms of securities are just simply inappropriate. Unfortunately warnings by ASIC are not enough and it needs to develop a boldness to challenge market practitioners who have little consideration for fairness.

Clearly, ASIC on the basis of its public statements, believes there is reason to be concerned with long-dated securities with limited protective clauses for retail investors.

So rather than a warning, some decisive regulatory response may be required. It is a pity when regulation is required, but in this case it results from a clear lack of market integrity for the reasons I outlined above.

The Portfolio

Start Value: $118,757.19

Current Value: $124,839.46

Average Yield: 8.71%

Clime Income Portfolio

Hybrids/Pseudo Debt Securities
CompanyMarket PriceMargin over BBSWRunning YieldFrankingTotal Return
High Yielding Equities
CompanyMarket PriceFY13 DividendGUDYFrankingTotal Return

Weighted Portfolio Return

Since Inception (24 April 2012): 4.03%

Since June 30, 2012: 5.12%

Market prices as at close August 30, 2012. Purchase price as of close June 29, 2012

John Abernethy is the chief investment officer at Clime Investment Management. Register for a free trial to MyClime, or attend a Clime investment seminar.

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