What happens at hybrid reset date?

Listed hybrid securities are offering attractive yields following a widening of credit spreads (the margin investors require over and above the government bond rate to compensate for increased credit risk).

Although many are now trading at a discount to face value, there is a reasonable expectation they will trade closer to face value as they move towards reset or maturity date, at which time holders can generally expect to receive a return of face value by way of cash or shares.

That makes it timely to take a look at what happens once the date has been reached and what options or rights, if any, the security holder has.

Classes of hybrids

The structure of hybrid securities has evolved over time in response to the issuers’ needs and changing regulatory requirements, and can be broadly grouped into five distinct types: income securities; reset preference shares; step-up preference shares; mandatory conversion preference shares; and convertible notes.

Income securities

These were the first generation of hybrid securities and are relatively uncomplicated to understand. They’re perpetual securities offering a floating rate of return at a set margin above a bank bill benchmark. Coupons (interest payments) are unfranked and, as the term “perpetual” suggests, they have no maturity date.

While the holders have no conversion options, the issuer does have the ability to redeem the securities at face value (usually $100) after a specified term (usually five years). Many have already been redeemed, with only a handful of securities remaining on issue. Examples include National Income Securities (NABHA), Macquarie Income Securities (MBLHB) and Suncorp Capital Notes (SUNHB).

Given that these securities were issued way back (1998-2000), the issuers can now redeem whenever they want; however the holders of the notes have no corresponding redemption rights.

These securities were originally issued with margins (over the bank bill rate) of between 0.75% and 1.25% (reflecting the issuer’s credit rating and credit market conditions at the time of issue). They’re now trading at margins in the range of 2% to 3.5%, representing deep discounts to face value.

As credit has become increasingly tight and expensive, it would appear unlikely that these securities will be redeemed or replaced in the near future.

Compared to the newer style of securities on offer, these older perpetual income securities hold little appeal to investors.

Reset preference shares (RPS)

These “second generation” hybrids go some way towards addressing investor concerns about the risks surrounding the perpetual nature of the income securities, namely the infinite duration volatility, which can severely affect the security’s price when credit margins widen (as we’ve seen recently).

Examples of RPSs include ANZ StEPS (ANZPA), CBA PERLS 2 (PCBPA), IAG Reset Preference Shares (IAGPA) and Powers Trust (PWSPA).

RPSs offer a more bond-like structure than income securities because holders do have the right to request redemption or conversion into shares, typically on reset dates.

So what happens at reset? While in theory the RPSs are perpetual, they can be exchanged, converted or redeemed in a number of circumstances that may be initiated by either the holder or the issuer.

Approaching reset, the issuer may vary the terms of the issue, including adjusting the next reset date, increasing or decreasing the margin and changing the frequency and timing of payments of distributions.

The issuer may also deliver an Exchange Notice to holders, outlining the method of exchange it intends to apply on the reset date – either conversion into ordinary shares at a predetermined discount or redeem for the face value of the securities.

Holders may deliver a Holder Exchange Notice prior to the reset date requesting that the issuer exchange their RPS at reset date (for ordinary shares or cash at the issuer’s option).

Step-up preference shares (SPS)

This style of security came about only a few years ago in response to regulatory changes requiring hybrids to “look” more like equity.

The feature of an SPS issue is that on first reset date the securities will be “remarketed” whereby the terms and conditions will be adjusted by the issuer and then offered to holders.

If the holders accept the new terms and conditions then the issue will continue until the next reset or remarketing date. Should the holders not accept the new terms and conditions, the issuer has the option to redeem the issue at face value, exchange for ordinary shares or increase the margin by the step-up margin.

The step-up margin was originally designed to be a penalty on the issuer to ensure that on the remarketing date the issuer will offer either market terms, redeem or exchange the securities. However, should margins remain wide due to the prevailing credit crisis, issuers may elect to accept the higher step-up margin (typically 1% to 2.25%) allowing the issue to continue.

Issues include CBA PERLS 3 (PCAPA), St George Bank SPS (SGBPC), Ramsay CARES (RHCPA).

Mandatory conversion preference shares

This is the latest style of hybrid offering and is perpetual in nature but does have a mandatory conversion into equity option, designed to ensure conversion.

Mandatory conversion conditions are usually struck to ensure either conversion or redemption is achieved on the conversion date. Holders have no exchange rights.

Issues include CBA PERLS 4 (CBAPB), St George Bank CPS (SGBPD & SGBPE) and Suncorp CPS (SUNPB).

Convertible notes

This form of security has more equity characteristics than fixed income traits. Convertible notes are securities that are required to convert into ordinary shares at either a specified quantity of shares or at a specific price.

What is unknown is generally the number of shares that holders will be receiving, as this is usually determined by the volume weighted average price (VWAP) over a period of trading days prior to conversion.

Holders of convertible notes, like other fixed income securities, receive a distribution while holding the notes and may also benefit from upward movements in the price of the underlying equity on conversion.

Issues include Macquarie Airports TICkETS (MAZPA), Myer Notes (MYFG) and Toll Reset Preference Shares (TOLPA).

There is always risk

All of this highlights the risks and uncertainties facing hybrid investors at reset/maturity stage. Reset terms will differ from issue to issue and it’s important to understand the terms and conditions attaching to a given hybrid issue before deciding to invest. There will also be other conditions such as “trigger” events (takeovers, etc), that may bring forward the redemption or otherwise affect a hybrid issue – all of which are set out in the respective prospectuses.

Jenny Zielke is a senior adviser and state manager of Investstone’s Queensland Office. This article first appeared in The Investing Times.