Why are my hybrids trading at a discount?

Sharemarket volatility is generally well understood. Most investors have experienced the ups and downs of market cycles before and are prepared to ride out the turbulence. A less understood and perhaps more puzzling concept to investors though is that of volatility in fixed interest markets.

Fixed interest markets do experience volatility. With traditional fixed interest investments such as bank term deposits and corporate debentures, the investor deposits funds, receives a fixed rate of interest during an agreed term and receives return of their capital on maturity. Volatility is not apparent with unlisted securities or term deposits held to maturity because they’re not being priced on a day-to-day basis in the way traded securities are – but it’s still there. It’s just you do not see it, but it would become apparent if you had to sell on the secondary market.

So what drives capital volatility in fixed interest markets? There are a combination of factors that will affect the capital value of fixed interest securities, including concerns about the performance of the underlying company (the issuer), changes in credit ratings, prevailing interest rates, the supply/demand for securities in the marketplace and changes in credit market conditions that might affect the way the market prices risk (credit spreads).

Changes in interest rates. Let’s look at how changes in prevailing rates might affect the capital value of a bond. Take a 10-year bond, issued with an interest rate (coupon) of 6%, with a remaining term of five years and a face value (issue price) of $100. Assume interest rates have risen and you can now purchase a similarly rated security for a term of five years offering a coupon of 7%. If you needed to sell your bond, the market would demand a 7% yield. Because the coupon is fixed, the capital value will have to be discounted. You might therefore expect to receive $96 if you were to sell your bond. Bond prices have an “inverse” relationship with interest rates: rates go up, bonds go down and vice versa.

Credit spreads. Another factor that affects bond prices is changes in pricing of risk in credit markets and that’s exactly what we’re seeing at the moment. All interest rate securities are caught up in the global credit crisis where the cost of debt has increased significantly.

Hybrid Securities. Investors in ASX-listed hybrid securities have seen the capital value of their investments drop over the past few months. One of the attractions of listed hybrids is the floating rate nature of the coupon, which provides a level of protection against the effect on capital value when interest rates rise. The coupon is adjusted at a fixed margin over a benchmark rate (usually the 90-day rate) on either a quarterly or semi-annual basis, so the coupon moves with changes in prevailing short term rates. However, it’s the fixed margin above the benchmark rate that is causing issues with pricing of hybrid securities in the market today. Although the distribution rate is floating, the margin above the benchmark rate is fixed until the first or subsequent reset date (which varies for each security).

Impact of higher risk premiums. Currently, due to the crisis gripping credit markets globally, buyers are demanding a higher risk premium to buy these securities. With margins fixed, as credit spreads widen, the securities will trade at a discount to face value in order to increase the yield. As an example of the widening credit spreads, consider the St George securities (SGBPE) listed in the accompanying table. These securities were issued at a margin of 160 basis points (1.6%) above the 90-day rate in December last year and now, just a few months later, are trading at a margin of about 220 basis points (2.2%). It should also be noted that volumes are extremely light in the domestic hybrid market and bid/offer spreads are wide. Forced sellers (possibly fund managers funding redemptions) are having to accept very substantial discounts in current markets.

Looking at the underlying assets and businesses of the hybrid securities. Investors in hybrids should look at the underlying assets and business of the company to determine credit worthiness. Most investment grade issuers have reported their half-year results to the market and have reported solid profits. Also keep in mind that most hybrid securities will convert to face value (issue price) at some point in the future – either by way of cash or ordinary shares (usually at a small a discount to prevailing market price). Again, the reset/maturity dates vary from issue to issue. Refer to the table for a summary of some popular hybrids on issue. Once the current credit crisis subsides and some level of normality returns, it would be expected that these securities will trade closer to face value and in the meantime, investors will be rewarded with higher income payments as coupons reset based on higher 90-day rates.

nHow the hybrids are performing
ASX	Security Name	Closing price	Coupon rate	Coupon type	Franking	Conversion to par	First reset / maturity date	Yield to first reset	Running yield	Credit rating
ANZPA	ANZ Bank Preference Shares	$100.00	8.34%	Floating	0%	Yes	15-Sep-08	8.70%	8.37%	A
CBAPB	CBA Perls 4	$196.90	5.88%	Floating	100%	Yes	31-Oct-12	9.40%	8.57%	A
NABHA	NAB Income Securities	$98.01	9.04%	Floating	0%	Yes	Perpetual	N/A	9.20%	A
PCAPA	CBA Perls 3 Preferred capital	$191.00	5.72%	Floating	100%	Yes	6-Apr-16	9.07%	8.48%	A
WCTPA	Westpac Trust Preferred Securities	$93.50	5.77%	Floating	100%	Yes	30-Jun-16	9.15%	8.49%	A
IANG	IAG Finance (NZ) Resets	$79.00	5.98%	Floating	100%	Yes	15-Mar-10	13.24%	9.04%	A-
SGBPE	St George Bank CPS II	$97.45	6.21%	Floating	100%	Yes	20-Aug-13	9.18%	8.89%	A-
WOWHB	Woolworths Notes	$98.50	8.44%	Floating	0%	Yes	15-Sep-11	9.08%	8.99%	BBB
STOPB	Santos Preference Shares (FUELS)	$90.60	5.98%	Floating	100%	Yes	30-Sep-09	12.37%	8.83%	BBB-
FCLPA	Futuris Perpetual Notes	$85.75	6.61%	Floating	100%	Yes	30-Jun-11	14.12%	10.44%	Unrated
26/2/2008 Citi Smith Barney Hybrid & Convertible Report

Jenny Zielke is a senior adviser and Queensland state manager of Investone Wealth Management.