Be wary of ‘ridicu­lous’ hy­brids

Money Magazine Australia - - INVESTING -

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.

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