Hybrids - Back to basics
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Ravi Reddy, Michael Wu and Nathan Zaia are equities analysts at Morningstar.
What are hybrids?
Given the recent onslaught of income security issues, we have decided to go back to basics.
Hybrids have been around for over 20 years. The structure of these securities has changed over time, as there have been changes in accounting and taxation rules and requirements by regulators and ratings agencies.
"Hybrid" is a broad term for securities which have both debt and equity characteristics. While not technically correct, the term is also commonly used to include pure debt securities such as retail bonds, floating rate notes and perpetual notes.
The more correct term is "interest rate security". There is not one generic type of security on issue. While some are quite similar, each has its own specific terms and conditions.
In the listed space, the bank-issued hybrids dominate in terms of size and the number of issues, in particular the major banks. They form an important part of banks' regulatory capital structure. Banks have strict regulatory capital requirements that need to be met.
For industrials, they also form part of a firm's capital management strategy, but without the regulatory requirements. A number of recent issues have been structured so they can be treated as equity by some ratings agencies for a specific period.
Types of interest rate securities
At a high level there are basically two types of interest rates securities: pure debt and hybrids. Within each category, there are a myriad of specific terms and conditions to distinguish each.
- Pure debt securities: These securities are like loans made by an investor to an issuer, which can be traded on the ASX. They pay interest periodically. But unlike ordinary loans, sometimes interest is deferrable – perhaps indefinitely. Being an interest payment as opposed to a dividend, they are not franked. These securities can be secured or unsecured with a fixed or perpetual term. Examples of these securities include retail bonds, subordinated notes and perpetual notes.
- Debt/equity (hybrid) securities: These are more like investments than loans as they can convert into equity. They are often referred to as convertible preference shares or convertible notes. Their terms and conditions are more complicated than pure debt securities and repayment of the principal can be in the form of cash or ordinary shares of the issuer. They pay franked or unfranked distributions periodically and tend to be unsecured, ranking just above ordinary equity. While they typically have some date at which redemption or conversion may occur, they are usually classified as perpetual as repayment or conversion is subject to conditions. So, they could potentially remain on issue indefinitely.
Investors should seek independent advice from a professional adviser before making an investment decision.
Investors need to understand the risks of investing in income securities. The old adage of "higher return equals higher risk" applies! These are not bank deposits and do not come with a government guarantee. They carry more risk.
While there may be opportunities for capital gains, the primary purpose of investing in an income security should be to derive a regular income stream. They should also be part of a diversified portfolio. "Don't put all of your eggs in one basket."
Typically, these securities rank just above equity and are unsecured, so in a wind-up scenario, an investor could lose all their capital, which happened to holders of hybrids issued by Babcock and Brown and Allco Finance.
Dividends for hybrids are often optional and non-cumulative, but typically there is a dividend stopper for the ordinary shareholders. So for a lot of hybrids, dividends don't have to be paid! A scenario would be where cash flow is tight, there is earnings pressure and gearing is too high. If dividends are non-cumulative, then missed dividends don't have to be made up. However, there is usually a dividend stopper, which means dividends on ordinary shares cannot be paid if dividends on hybrids are stopped.
There are a number of specific risks:
- Liquidity risk: While they are listed, liquidity can be low, with the effect of making the bid/ask spreads wide. Timing entry and exit is therefore important.
- Credit risk: This is the risk that the issuer can't pay distributions or repay the principal. A higher risk demands a higher return.
- Interest rate risk: Changes in interest rates will impact distributions for floating-rate securities. While distributions of fixed-rate securities will not be impacted by interest changes, their price is more likely to be impacted – a declining interest rate environment would likely be a positive for the price, while a rising interest rate environment would be a negative.
- Spread risk: Credit spreads move around due to changes in the actual or perceived risk of the issuer or the market. An increase in risk will likely see credit spreads widen, meaning the price of the security has fallen.
- Term risk: This is the risk of the security staying on issue for a shorter or longer period than expected.
- Conversion risk: If a security is converted into ordinary shares, then an investor wishing to exit and reinvest in another income security could be left holding the shares and would therefore be exposed to adverse moves in the share price.