The trouble with hybrids

PORTFOLIO POINT: Hybrid issues have inbuilt risks for investors. By comparison, bonds and cash have consistently outperformed.

Two critical factors have coalesced to spark growing interest in hybrid securities: investors are looking hungrily for yield, yet they are still highly wary of volatile equity markets.

Companies are going to the market and issuing hybrids that offer attractive yields of 500 basis points and 450bp, respectively, above the bank bill swap rate (BBSW), and investors are queuing up.

But how well are hybrids understood? Are investors cognisant of the risks and rewards? Certainly, in PIMCO’s view, there are still misconceptions about hybrids.

Understanding the appeal of hybrids has to be seen in the context of investment markets post the Global Financial Crisis (GFC). It’s aptly summed up by that immortal Bob Dylan hit single in 1964 – The Times They Are a-Changin’. Four years ago, “income” was a concept synonymous with tax-efficient dividends. Cash flows accumulated effortlessly and returns were ample. That was the ‘old normal’ – but the old normal is no more.

What worked then now seems unthinkable. The core of many investors’ investment philosophies – equities providing sustainable income streams and capital growth – now seems like a fairytale. The combined forces of deleveraging, deglobalisation and re-regulation have heralded a new era, replete with concerns surrounding European solvency, US financial and political repression, and an international banking system under pressure to acknowledge non-performing loans and re-capitalise.

The playing field has changed, equities are more volatile, and now, more than ever, investors find themselves asking: How can I preserve my wealth, harvest my income, and balance my portfolio?

In this scary new world (to misquote Aldous Huxley), hybrids look a viable option; they appear to offer income security (like a bond), but with a higher yield. At the same time they offer the potential for capital appreciation associated with equities.

But with those rewards come risks, and it is pertinent for investors to understand those risks in order to determine whether hybrids meet their risk profile. For example, issuers may have the right to defer coupon payments for years; others can do so indefinitely. Companies can also decide not to redeem their hybrids.

Put simply, in times of stress, companies can cut payments or choose not to give investors their investment back when they would be expecting it.

What these risks reflect is the position hybrids have in the capital structure; in a pecking order that has government guaranteed debt at the top (lowest risk), hybrids are second last, with equity bringing up the rear.

Many investors rely on hybrid instruments to diversify portfolios – often as a substitute for fixed income. But is this an accurate reflection of their risk and return characteristics? The evidence shows that hybrid instruments act more like equities in bear markets and more like fixed income in bull markets, diluting returns but not necessarily diversifying risk.

Research done by PIMCO shows that over the past five years to June 30, 2012, bonds (Australian and global) and cash have outperformed hybrids, with global bonds returning 11.6%, Australian bonds 9.6%, cash 5.8% and hybrids 4.2% – and that does not take into account the much lower risk profile or volatility of bonds and cash.

In our view, investors today are likely to be better off lending at the top of the capital structure than owning at the bottom of it. Tight credit and financial conditions may see investment grade companies paying 6%-10%, and high-yield companies paying up to 12% to access new capital. In today’s volatile markets, surrendering some yield and having the security of high-quality, well-capitalised multinationals’ higher ranking debt might be the better option.

Additionally, investors may increasingly find that conservatively positioned portfolios, especially those emphasising quality and liquidity through a diversified holding of senior securities, may deliver a better relative risk-adjusted real return.

Australian investors who do not adapt to the challenging environment may struggle to preserve their wealth and harvest their income. The age of high income and high returns at the bottom of the capital structure are, in all likelihood, over. In order to continue to maintain adequate sources of reliable income, investors need be aware of the real risks of any investment they make.

Peter Dorrian is head of Global Wealth Management at PIMCO Australia.