Hybrids versus fixed-income ETFs
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Christine St Anne is Morningstar's online editor.
Five years ago, investors had some heady expectations of what a market could actually deliver. It seemed markets would continue to deliver their dizzy returns.
Products such as structured and gearing vehicles were part of a new suite of products being offered to investors with insatiable appetites for risk and reward.
Five years later and expectations have been dampened. Following the global financial crisis, investors are now somewhat content with 6 to 8 per cent returns.
It was in this market that financial planner Russell Medcraft saw the benefits of hybrid securities.
Medcraft, who heads financial services firm Financial Choice, says hybrid securities gave investors a reasonable level of capital security with a "little kick" in return.
Hybrids have proven popular with investors who have been attracted by the returns that come from the structure of these securities.
As the name suggests, hybrids are securities that include a combination of debt and equity characteristics. These securities are issued by companies as part of their capital management strategy.
In the case of banks, such securities are used to meet their capital and regulatory requirements.
They also provide a higher return than term deposits and provide regular distributions, but unlike term deposits, investors can easily exit these securities because they are listed.
According to a recent Morningstar report, hybrid securities do carry a number of risks. In the case of these securities, the old investment adage applies - "higher return equals higher risk".
Such risks include liquidity, credit, interest rate, spread and conversion risks.
Although hybrids are listed securities, Morningstar notes that liquidity can be low. Therefore, timing entry and exit is important.
The issuer of a hybrid security may also not be able to pay their distributions or repay the principal.
These hybrid securities also rank above equity and are unsecured. An investor could lose their money if the company winds up, as was the case with hybrids issued by Babcock and Brown and Allco Finance.
While the interest payments of fixed-rate hybrid securities won't be affected by changing interest rates, their price will be affected.
A falling interest rate market environment means a positive price for the hybrid, but when interest rates rise, the price of the security falls.
Credit spreads can also move due to changes in the 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," the Morningstar report says.