Be wary of ‘ridiculous’ hybrids

Hybrids are a “ridiculous” product for retail investors, according to Greg Medcraft, the outgoing chairman of the Australian Securities & Investments Commission in an interview with The Australian Financial

Review in July. In many cases, if a bank gets into financial trouble hybrids can be converted into bank shares, which may be worth less than the initial investment or may be written off completely, resulting in a total loss of capital.

This is what happened to some hybrids offered by overseas banks during the GFC.

The four major Australian banks have issued around $27 billion worth of hybrids, which have been popular with retail investors because of the high yield and 100% franking credits.

Medcraft believes the billions of dollars of hybrid securities issued to retail investors by the major banks will eventually cause problems for the financial system. He said it was notable that hybrids had been banned for retail investors in other markets like the UK.

BT Financial Group’s Riccardo Briganti says ASIC has a very strong view that people don’t understand the characteristics of hybrids. He does not classify hybrids as fixed income. “Hybrids are a lot closer to equities. It goes back to what is your definition of fixed income,” he says.

Morningstar analyst John Likos agrees that hybrids are not substitutes for fixedincome securities or term deposits. “We believe they should be treated as a separate asset class with their own asset allocation.

“And in our view, hybrid securities should only be the domain of the medium- to highrisk investor as part of a diversified portfolio. Never the low-risk investor whose primary concern remains the preservation of capital. By their very nature hybrids have both debtand equity-like features.”

Likos says that Australia’s major banks remain among the strongest in the world with regards to their financial and business risk profiles, the former supported by a more stringent application of global capital requirements than many of their global peers.

As for Medcraft’s point that “if a bank has any trouble [hybrids are] the first line of defence”, Likos says a glance at any capital structure chart will show shareholders will be the first line of defence, followed by hybrid securities.

Likos says Medcraft is likely to be thinking of what happened recently in the resolution of the Banco Popular failure in Spain. “Namely, a nonviability event is likely to lead to the complete writedown of equity and hybrid securities simultaneously. Yet this is no reason to avoid both equity and hybrid securities. If anything, their low recovery rates are reason enough to exercise greater due diligence prior to investing,” says Likos.

ASIC warns that hybrids’ interest payments are not guaranteed and are paid at the discretion of the issuer. On top of this, missed interest payments do not accumulate.

Issuers do not guarantee that the investment will be repaid and, unlike savings accounts or term deposits with a bank, hybrids are not covered by the government guarantee. “Your investment is not secured by a mortgage or security over any asset,” warns ASIC.

The hybrid will convert into ordinary shares in the issuer on a fixed date, usually eight to 10 years after issue, provided that the issuer’s ordinary share price has not fallen by more than 50% in that time.