The myth about mutant stocks
Hybrid shares are complex instruments that promise more than they deliver. Better to avoid the pitfalls and play it straight.
Hybrid shares are complex instruments that promise more than they deliver. Better to avoid the pitfalls and play it straight. A HYBRID is all well and good for a car but that's where it should end.In the hands of the big end of town, hybrids are mutant share issues masquerading as a bond despite not having a fixed interest rate, much less giving you your money back at the other end. Not even if you ask nicely.Usually called converting preference shares, your typical hybrid has a maturity date in the never-never. The bank can redeem them, at its own discretion, usually after about five years.Their superficial attraction is that the dividend is based solely on what interest rates are doing and so can't be manipulated, yet is fully franked, sort of - but I'm coming to that.Buyer beware is all I can say. Most have gone backwards bad luck if you need your money early. But that's nothing. Whether you like it or not, you only get paid back by way of shares of the mother stock, admittedly with a few extra thrown in, so why not buy those in the first place?The 7.5 per cent or so yield beats a term deposit but then a hybrid ranks three rungs lower on the capital safety ladder.Frankly, you're not getting much compensation for investing in something that's only marginally less risky than a bank's ordinary shares.Yet the yields on bank shares are way higher. Should you suddenly need cash, and you never know, hybrids are arguably riskier because, unlike bank shares, they hardly ever trade, which makes them hard to sell in a hurry.Though ANZ's issue last year was rushed, the $100 its investors paid has dropped to $97.98. And the Commonwealth's PERLS are anything but. One of them, issued at $200, has slumped to $178, so you'd have to hang on like grim death to get your money back - and then it will probably be in shares. The trouble is that as soon as a new hybrid comes along, the prices of the previous models drop as the smart money updates into a better yield.If you hang on to them, and don't mind finishing up with bank shares, it's true there's always the franked dividend.Glad you mentioned that because it's pure sleight of hand. Sure, there's a 30 per cent credit on the dividend that you can claim back on your tax return. Even if you don't pay tax, you can still ask for a refund. But there's a catch. While franking is added to shares, it's deducted from hybrids.For example, Westpac's convertible preference share offer that opened on Friday pays a flat 3.25 per cent more than the variable 180-day bank bill rate.That's 7.7 per cent fully franked. But instead of getting about 11 per cent all up, as you would from a stock paying the same dividend, when you add in franking, you get 5.4 per cent.See what I mean? The banks work out the payment with franking, then take it off. So the franking is based on the 5.4 per cent, not 7.7 per cent.Since you're going to finish up with Westpac shares, which are yielding almost 11 per cent including franking, why bother with the hybrid? Especially when in the next year or so Westpac's dividend should be stable and possibly higher, whereas the hybrid yield and perhaps the price will drop if interest rates fall.At least the subordinated note issues that opened last week from ANZ, Colonial and Tabcorp are more straightforward.These pay you back in cash when they mature and, despite being called subordinated, are one rung higher in safety.ANZ's 10-year notes pay a flat 2.75 per cent over the 90-day bank bill rate and there's no funny business about franking credits on account of the fact you don't get any.They yield about 0.5 per cent less than hybrids, though Tabcorp's 25-year notes will yield 8.4 per cent.And they're leaving the showroom so fast that ANZ says it'll take an extra $1 billion.When a bank is that keen to borrow, you have to wonder who's getting the better deal.