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Choosing high-quality hybrids

Christine St Anne  |  26 Sep 2013Text size  Decrease  Increase  |  

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Christine St Anne is Morningstar's online editor.

 

The recent article titled Overcoming hybrid insecurities delved into a number of risks surrounding hybrid investing. Price volatility, interest-rate risk, early redemption risk and maturity risk were just some of the common risks investors need to consider before investing in hybrids.

Another key risk was the threat of default from the companies issuing hybrid risks, also known as issuer risk.

Readers are no doubt aware of ASIC's repeated warnings about the viability of companies issuing hybrid securities. According to ASIC, hybrid securities may not always be safe despite being issued by reputable companies.

It can be tricky for investors to choose the quality hybrid securities that will give them both security of income and investment return. As the aforementioned article pointed out, the issuance of hybrid securities by Australian companies has been strong over the past year.

Morningstar recently introduced a credit pick list for interest-rate securities such as hybrids. To make this list, companies must have credit profiles that reflect their stability. Such credit profiles include no risk of default, credit deterioration or structural risk.

"This approach facilitates the likelihood of stable investor income over the life of the investment," Morningstar credit analyst Nicholas Yaxley says.

A key component in the assessment process is Morningstar's economic moat rating. An economic moat is a structural feature that allows a company to sustain excess returns over a long period of time.

Without a moat, profits are more susceptible to competition. Companies with a narrow moat are likely to achieve normalised excess returns beyond 10 years, while wide-moat companies are likely to sustain excess returns beyond 20 years.

Of course, the moat rating is not the only analytical tool used by Morningstar. Morningstar also looks at interest coverage and leverage ratios, debt covenants, cash flow variability and the use of free cash flow.

However, the moat rating allows Morningstar to focus on industry structure and competitive advantage in its issuer risk analysis.

"We are more likely to assign low or medium issuer risk ratings to firms with moats and more likely to assign high or speculative issue risk to firms without moats," Yaxley says.

So what sorts of companies are in the Morningstar credit pick list? Premium subscribers can get access to specific companies on this list in the article titled Moat-focused credit pick list.

All these companies share consistent characteristics. Companies with a moat rating have a natural defensive characteristic that insulates profits from competitive forces. This makes their credit quality less likely to suffer when negative factors arise and spreads are therefore less likely to blow out.