Look be­fore leap­ing

Care­fully con­sider the dan­gers be­fore in­vest­ing in these pop­u­lar in­stru­ments

Money Magazine Australia - - SHARES - STORY SU­SAN HELY

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.

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