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What's driving Australia's hybrid securities?

Morningstar staff  |  05 Jun 2017Text size  Decrease  Increase  |  

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Hybrid securities have continued to perform strongly in 2017, rallying almost 50 per cent in some instances.

 

Technical factors are providing the greatest tailwind to the domestic hybrid market, says John Likos, Morningstar's head of credit research.

"We expect about $4 billion of supply will be withdrawn from the market in the form of redemptions without replacement issues between late 2016 and 2017," Likos says.

"These include the Woolworths Notes II and Origin Energy Subordinated Notes, both of which were called and not replaced in late 2016."

He also mentions the Tabcorp Subordinated Notes redemption and the announcement of the intended redemption of the ANZ Subordinated notes, which have occurred in 2017.

"Later in the year, we believe the Goodman PLUS II and the Caltex Subordinated Notes are more than likely to be called and not replaced," Likos says.

While he believes the outlook for hybrid securities "looks stable through 2017," Likos foresees potential price weakness in 2018, as supply increases in line with major banks continuing to increase their capital positions.

"Although we don't anticipate any major price corrections, we are beginning to emphasise caution in the current environment as a greater proportion of our hybrid coverage list continues to move into fully or overvalued territory," Likos says.

He reiterates the importance of not viewing hybrid securities as traditional fixed-income products, "nor should they be considered a substitute for low-risk investments such as term deposits. Therefore, they should offer a yield premium over these lower-risk products".

Morningstar subscribers receive regular analysis on Australian hybrid issuances, including access to the new Hybrids Guide.

But what are hybrids?

Australia's financial services regulator, the Australian Securities and Investments Commission (ASIC), regularly reminds investors that hybrid securities are not traditional fixed income. They contain several equity-like features, which means they should not be considered a substitute for either fixed income or term deposits.

There are four types of hybrid securities: subordinated debt, perpetual securities, convertible preference shares, and capital notes.

Subordinated debt

These securities are typically long-dated--sometimes up to 60 years--and contain equity-like terms. These include subordination, coupon deferral, and loss absorption.

Subordination means they rank behind other debt securities in the event of a winding up of the underlying asset.

Coupon deferral means they allow mandatory or optional coupon deferral options.

Loss absorption means they allow the issuer to write down unpaid coupon payments.

Perpetual securities

These typically comprise two components: a fully-paid debt security, and an unpaid preference share. These two components are often linked, and together constitute the perpetual security. They are often categorised as hybrid securities in that, like common stock, they don't have a maturity date.

Although the issuer retains the right to redeem the securities at certain stages of their life, they are not obligated to do so.

Investors' only option of redeeming the notes is by selling on market, unless the issuer voluntarily decides to redeem them. They generally rank below subordinated debt and allow deferral of interest payments.

Convertible preference shares

The name of these securities stems from the idea that holders receive preference over common equity holders to receive distributions and repayment of principal in the event of a winding up.

Like traditional debt, they pay a regular and defined distribution to holders; however, like equity, they have an element of permanence about them as there is no guaranteed date of redemption, that is, no maturity date.

Capital notes

These are similar to convertible preference shares, subordinated, convertible, redeemable and transferrable, unsecured, and pay non-cumulative distributions that are franked.

Being perpetual, they have no fixed maturity date and could remain on issue indefinitely if they are not redeemed, converted or written off. Issuers must convert capital notes into ordinary shares if the scheduled conversion conditions on the scheduled conversion date are satisfied.

Investor benefits

Relative to equity investments, hybrid capital is generally cheaper. This is often reflected in the equity dividend yield premium relative to the hybrid yield.

They offer greater tax incentives. Coupon payments from hybrid securities are recognised as expenses on income statements, lowering the taxable income.

Hybrid securities offer an alternative funding source to the more common equity and senior debt options, providing balance sheet flexibility to issuers. They also provide a level of issuer flexibility regarding distributions and funding tenor.

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