Caution urged on hybrids
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Christine St Anne is Morningstar's online editor.
Corporate watchdog ASIC recently reissued its warning to investors about investing in hybrids.
It comes at a time when a plethora of hybrid offerings have come onto the market. It also comes at a time when investors are hungry for yield.
The attractive yield returns from hybrid securities have certainly appealed to investors. Morningstar analyst Tim Wong says the hunt for yield can be "seductive" investing.
Before investors get seduced by these attractive returns, they need to appreciate the key characteristics behind these securities in order to understand how they fit in a portfolio.
Many investors widely use hybrids in the defensive part of their portfolio. Morningstar's view is that hybrids are not suitable for this role because they possess both debt and equity characteristics.
"We advise refraining from using hybrids as a core defensive portfolio allocation for several reasons," Wong says.
One of the key reasons is that, historically, hybrids like equities have tended to fall in value when growth slows. This often coincides when there are concerns about a company's ability to service its debt.
In worst-case scenarios, distributions are deferred. Examples of this include hybrids issued by PaperlinX (PPX) and Elders (ELD), which suffered as the companies stopped paying their income distributions.
Wong says hybrids rank behind other bondholders and therefore only have claims on a defaulting company's assets once the claims of other debt holders have been met.
"This significantly diminishes the hybrid's worth in times of stress, giving it more equity-like qualities," Wong says.
A recent Morningstar report on the fixed-interest sector also found hybrid issuers can also impose unfavourable terms such as retaining the option to convert, or retiring the security before maturity to refinance at lower interest rates.
Liquidity can also be problematic when risk aversion spikes - hybrids can be thinly traded, as was the case in 2008.
A number of notable fund managers have not invested in hybrid securities in recent years. According to Morningstar research, the managers of the Bentham Global Income , Colonial First State Enhanced Yield  and Schroder Credit Securities  funds all cut their exposure to hybrid securities dramatically from 2007.
As noted earlier, liquidity can be an issue in the hybrids market. It was one of the reasons Bentham's Richard Quin stopped investing in them back in 2007.
Quin also found there was a change in the style of the issuance of the new hybrids coming onto the market. As an institutional investor, he found investors did not have as many rights as before and many of the hybrids did not have research ratings.