Look before leaping

Carefully consider the dangers before investing in these popular instruments

Do you hold hybrid securities in your investment portfolio? If you run a self-managed superannuation fund or have visited a financial planner, the answer is probably “yes”. Investors who are hunting for yield and franking credits are often advised to load up on hybrids because cash and term deposits are giving historically low returns.

For example, take the hybrid from ANZ known as ANZPF. It was launched in 2015 and raised $1 billion. It pays out the bank bill swap rate (BBSW), which was 1.9% for three months at the time of writing, plus 3.5%pa, for a total of 5.4%pa, a higher rate than for cash and term deposits.

It is not surprising that hybrids have caught the attention of retail, rather than institutional, investors. Retail investors currently hold around $44 billion in hybrid securities issued by listed Australian companies and banks since January 1991, when ANZ issued the first domestic converting preference share.

John Likos, Morningstar’s director of equity and credit research, says the popularity of hybrids is partly due to the low-return investment climate. But he says that hybrid securities should not be considered a like-for-like replacement for term deposits or pure debt. “We believe they should be viewed as a separate asset class with their own asset allocation to fully benefit from diversification.”

Super funds that have been pumping up their cash options with debt securities such as hybrids received a warning from the regulator, APRA, recently about accurately disclosing what falls under the definition of the cash asset class. APRA told them that “cash equivalents represent short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value”. But hybrids and other credit securities, it warned, do not exhibit the characteristics necessary to be considered as cash or cash equivalent.

What is a hybrid?

Well-known companies and banks borrow money from investors in return for making interest payments. Hybrids blend some of the features of debt (fixed interest) with equity (shares), hence the name hybrid. Hybrids include unsecured notes, convertible notes, capital notes and other convertible preference shares. Each one has particular terms, time frame, conditions and interest rates, which makes it hard to generalise. They are typically traded on a secondary market such as the ASX.

The growth in hybrids has been spurred by new capital requirements under the global Basel III framework for the banks. Also, companies find it typically costs less to

issue hybrids than shares. And BetaShares recently launched an exchange traded fund, BetaShares Active Australian Hybrids, which holds 84% of its assets in bank hybrids.

But not everyone is a fan of hybrids. Greg Medcraft, outgoing chairman of the Australian Securities and Investments Commission, told The Australian Financial Review last year that 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 hybrid securities were a “ridiculous” product for retail investors and it was notable that they had been banned for retail investors in other markets such as the UK.

“If a bank has any trouble, they’re the first line of defence,” Medcraft said. “If you wipe out retail and all those retail investors are superannuation investors, you are robbing Peter to pay Paul. You’ve seen already overseas that there were real issues in exercising against them when banks got into trouble.”

Understand how they work

Certainly hybrids are complex products that you need to fully understand before you commit your money. “Hybrid securities may not be suitable for you if you need steady returns or capital security,” says ASIC.

There are a number of risks with hybrids. For a start they are not covered by the federal government guarantee that applies to bank deposits and term deposits.

Hybrids give the issuer, such as the bank, great flexibility. Some hybrids have terms and conditions that allow the issuer to exit the deal or suspend interest payments whenever they want. This means that there’s no guarantee of receiving a dividend or even getting your money back.

Also the price can drop below what you originally paid, making it hard for you to get out of the investment.

Hybrids come way down the list of who can claim the company’s assets if it gets into trouble.

“Investors should always understand the capital structure positioning of their investments as part of the investment due diligence process,” says Likos. He says not all capital structures are created equal. Unlike a six-month term deposit that redeems after the six months, these securities don’t redeem or convert into shares for a number of years, although they can be sold at an uncertain price in the interim. Some are very long-term investments – 60 years, for example. The interest earned adjusts to market every three months or “floats” because it is attached to the bank bill swap rate. This means that the income is not stable.

The bulk of new bank issues are labelled “capital notes” or “converting preference shares”. These will convert the face value to an equivalent value of ordinary shares at a future date, which is typically eight years from issue. There is usually an option for the instrument to be redeemed after about six years. This can cause confusion as investors may wrongly assume they will be paid at the earlier date, although this is merely an option for the issuer, subject to APRA approval.

Exposure to property

PIMCO’s Robert Mead, head of portfolio management for Australia, says that retirees need to be aware that if they hold bank hybrids, they have a high exposure to the property market through the bank's mortgage lending. Most investors are already exposed to property through bank shares in their portfolio as well as their own home.

“In this current environment of a fully priced Australian residential property market, increasing exposure to deeply subordinated Australian hybrid bank capital instruments or stocks as a source of income further concentrates this portfolio risk,” says Mead.

ASIC’s last report on hybrids outlined concerns about the sales process and the incentives such as underwriting commissions. Investment banks underwrite the corporate issue, which is heavily sold through wealth management, private banking, stockbroking and financial advisory firms.

ASIC wants investors to be aware of the distribution chain and the incentives. It reviewed five hybrid offers beginning in March 2012 and found that clients were sent emails with summaries setting out key benefits, much like advertisements, showing interest rates and income but without any mention of risks.

ASIC says if you don’t have the time or inclination to read the full prospectus, at the very least you should take in the “investment overview” and “about the security” sections, focusing on the risk summary.

Or you need to find a financial planner who is familiar with hybrids. They need to have experience in financial analysis to fully understand the risks.

While most hybrids are traded on the ASX, they are often less liquid than shares in the company that issued them. This means that there are fewer buyers and sellers in the market for this type of investment, and if you need to exit your investment in a hurry you may have to accept a lower price.