How to find quality hybrids
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Nicholas Yaxley is a Morningstar credit analyst.
However you describe hybrid securities, no one can deny the substantial growth in this market over the past few years.
Historically, the activity in this market has been sporadic but since January 2011 we have been witness to $28 billion in new issuance from listed Australian companies.
This growth has been primarily driven by the banks as a result of the new Basel III framework. This framework is being implemented over a number of years and the new capital requirements were implemented on 1 January 2013.
The majority of these instruments are heavily structured to meet the new Basel III requirements, and as ASIC commented in a recent report, they are "complex investments that even experienced investors struggle to understand".
Although they are complex instruments, Morningstar uses a consistent methodology to assess their quality and suitability for retail investors.
Firstly, it is important to distinguish the product type. "Hybrids" is a very generic term that basically means the instrument is part debt and part equity.
But if we break it down there is a vast array of product types: subordinated notes, capital notes and convertible preference shares. All carry distinct terms and conditions, which make it difficult to standardise a credit assessment.
Once the product type is established, Morningstar moves onto a muti-step process to assess the quality of the issuer and whether or not the premium being offered is adequate for the embedded risk.
The most important step in this process is Morningstar's fundamental analysis of companies, which revolves around its economic moat methodology.
Generally speaking, economic moats strengthen credit quality and are especially important for longer-dated securities such as hybrids.
Morningstar stresses the importance of an economic moat when investing in long-dated securities because the relevance of a company's financial health today decreases over time.
For example, over a 30-year period a lot can change including capital structure, management strategy and business operating environment, but the relevance of structural traits (an economic moat or lack thereof) increases over time.
Therefore, a company's structural position is more valuable as Morningstar moves beyond time horizons for which it can make a reasonably informed financial health forecast.
Based on this assumption, Morningstar is far more comfortable investing over the long term in companies with economic moats than those without them.