Stick to the odds and main themes when investing in fixed income securities
The odds of a listed hybrid losing money from the embedded credit risk within and the main underlying industry and global trends need to be key considerations for fixed interest investors.
A) The odds of loss? There are two components here arising from the embedded credit risk, a) the odds of a negative movement in capital price based on credit spread widening before ultimate recovery and b) the odds of an issuer or security defaulting and not ultimately recovering.
The odds of a major bank defaulting are very low partly because the federal government will likely assist them if they get into trouble. You don't need much credit spread to compensate you for these low odds if you are just buying senior ranking bonds such as the CBAHA. However, the major banks have also issued alternative tier 1 hybrids, such as the CBAPD.
What are the odds of this type of security having the loss provisions invoked whereby investors lose their money but the bank does not default? The odds will determine the spread you need for this particular risk. Say you earn a 4% p.a. credit margin, receive that for 25 years and then have the write off clause invoked. Ignoring reinvestment of coupons you have broken even. You invested $100, earnt $4 p.a. for 25 years = $100, then lost your $100 initial investment. No good. If you think every 10 years there will be a write off you only earn $40 before losing your $100. Hopeless.
If you believe 100 years is the correct number, then you earn $400 before losing your $100. Excellent. We'll go with 25 years for now. You don't want to break even, you want to beat the odds. Putting the margin above 4% beats the odds, our odds anyway. I would use 5% to get a return, still not great but at least it is positive. The final risk is the mark to market risk where there is temporary loss but the security ultimately recovers to $100. This risk increases with the term to maturity.
You would want something extra here as well, maybe another 0.5% p.a.. Thus on our back of the envelope calculations we want BBSW 5.5% to invest in CBAPD or any other alternative tier 1 hybrid. They are not there yet. If you think 25 years is too short and that a write off would only happen 1 in 100 years, then they are fairly priced now around BBSW 3.5%. We think they are riskier than that. You get the picture. You need to know, or estimate, the odds and play them over the long term. You can do similar estimates for high yield bonds and hybrids.
B) The main underlying investment trends? Clearly fossil fuel prices are falling and there is a global boom in renewable energy. energy efficiency, carbon neutrality and sustainability. BR Securities would avoid AGL, Origin and Caltex hybrids for now.