Christine St Anne: Hybrids have become increasingly popular with investors, but what are the risks and how do they fit into a debt or equity portion of the portfolio? Today I'm joined by PIMCO's Michael Dale to give us a better insight into these securities.
Michael Dale: Thanks for having me. Appreciate it, Christine.
St Anne: So, Michael, a lot of these hybrids have come into the market, what should investors be mindful of?
Dale: Well, I think, what we try to say at PIMCO is that investors really need to be cautious as classifying hybrids is a fixed interest alternative, because often hybrids will act like bonds in bull markets, but act like equity in bear markets, and the very reason why you invest in fixed interest is to have an asset that's appreciating in value while others are falling.
St Anne: So, can you give us some examples of the risks involved?
Dale: Absolutely. Well, like a fixed interest investment coupons are contractually paid, however hybrids which are being classified as a fixed interest investment will pay you a coupon or income like return, however, these are very much discretionary. In a risk of market, you may find that those discretionary coupon payments may be withheld by the issuer, and so when you need income at the most important times, you may find that the tap is turned off given the optionality that the issuer has with these securities.
Also in terms of capital structure, these securities lie just ahead of equity, and so in the event of a windup of a company, you're actually subordinated to all bond investors, and therefore should be paid for the risk that you're taking. Finally, the issuer has in-built into these contracts over these securities the option of extending the maturing from the call back optionality embedded into the security. So, the investor may find that they're investing for up to around 25 years, so are you being paid the return for that maturity level, I don't think so.
St Anne: Michael, is there ever a good time to invest in hybrids?
Dale: Well, investors really need to take into consideration the risks that are involved with hybrids. First and foremost, are they being paid for the risks that they've taken, the risk that we've already talked about. The fact that their coupon could be turned off in light of a bad run for the company. The fact that you're subordinated versus all issuance of debt, and just above in the capital structure than common equity, and so when they take all that into consideration, the investor that is, they need to then really ask themselves have they got an investment that fits their asset allocation in their portfolio. So, the question is, do you ever really want to invest into hybrids, and I'm not ever saying not to own a hybrid, but I think you need to say to yourself, what is this hybrid doing in my overall asset allocation?
You should look at whether you can purchase an equity, or common equity in the same company, and on a fully franked level is that dividend paying you as much as the hybrid. So, these are the kinds of things you need to ask yourself before investing into a hybrid, but all that we're trying to say is it shouldn't be classified as a fixed interest alternative that pays you income, because obviously, as I've mentioned before hybrids will act like equity in bear markets, and that's not what you invest in fixed interest for.
St Anne: Michael, but in an environment of subdued returns, shouldn't investors look to get that extra return from hybrids?
Dale: Well, Christine, no doubt the last three to six months has been a fantastic windfall for risk on investing, and no doubt the investments made into the hybrids of recent months has been a successful transition out of cash and term deposits. But we'd like to say that any bad news that was to come to the market over the next three months would leave these risk assets very, very vulnerable to a sell off, and therefore we don't think that investors should be rushing into risk assets like hybrids by looking for yields. So when you can find comparable yields, much higher up in the capital structure in the same bonds, issued by the same companies, hedged into Australian dollars, we'd say that is a much better alternative for investors given the volatility in markets we're still facing.
St Anne: So, Michael, what kind of assets can investors look for in this low return market?
Dale: Well I think, first and foremost, investors really need to ensure diversification amongst their portfolio. In Australia, we've been heavily skewed towards risk assets for so long now, at the detriment of investment returns. Bonds have been able to produce double digit returns both in global and Australian strategies for a number of years, and whilst may not be able to produce those returns going forward have definitely been seen in a better light from an investor's point of view to the fact that you can appreciate in value, unlock a term deposit for that matter, when other assets, particularly assets are falling in value. So, I think, going forward, the ultimate diversification of one's portfolio is going to be ultimately the most crucial aspect.
St Anne: Michael, thanks so much for your insights today.
Dale: Thanks very much, Christine. Appreciate it.