Nicholas Grove: Investors may have noticed the recent surge in hybrid issues over the past several months from big names such as Woolworths, Origin Energy, Westpac, just to name a few. You may have also heard terms bandied about such as perpetual notes, subordinated notes, and convertible notes, but what are all these instruments, how do they work, and what does it all mean?
Here to teach us a bit about them, I'm joined by Morningstar Equities Analyst, Ravi Reddy.
Ravi, thanks very much for joining us.
Ravi Reddy: Thanks, Nick.
Grove: First of all Ravi, broadly speaking what is meant by the term hybrid?
Reddy: Well, these have certainly been the flavor of the month. If we go back to the Woolworths' notes issue last year, then raisings have been more than A$6 billion. There's been a lot of interest. A hybrid is a security which has both debt and equity characteristics, but it's also being commonly used to describe a pure debt securities, such as subordinated notes and retail bonds. The more correct term for this is interest rate security.
It's important to note, there's not one generic type of security on the issue. Whilst some of the securities only show similarities, each has its own unique terms and conditions. You only have to look at some of the prospectuses, which are more than 100 pages to realize that there are a lot of differences, and each has its own specific terms and conditions.
Grove: What sort of risks do these securities carry, and conversely what are their benefits, particularly when it comes to retail investors?
Reddy: There are quite a number of risks. There is credit risk, interest rate risk, spread risk, liquidity risk, conversion risk, term risk. We discuss these in more detail in the report we've recently published, but I think what investors need to understand is that these aren't bank deposits with a government guarantee. They offer a higher return, which means there is a higher risk. Also, typically these securities are unsecured, and they rank just above ordinary equity. So, what does that mean, in a wind up scenario, you could end up losing all your capital, and this has happened in the past with some previous issues by like Allco Finance, and some of the Babcock & Brown issues, so I think that's what investors need to realize.
Yes, but there are benefits, because it allows investors to invest in a security where they can get a higher rate of return than say a bank deposit, and it also allows investors to - you can trade them, so it means you can - if you do need access to capital you can sell them on market. While they rank above ordinary equity, they tend to be less - the prices tend to be less volatile than ordinary shares, and the other thing is you can get regular distributions. They typically pay distributions quarterly, or - and some pay semi-annually, so there are benefits as long as people understand the risks of what they're getting into.
Grove: Ravi, what sort of qualities do you look for, and should an investor look for, when it comes to these types of securities?
Reddy: We look for a high degree of certainty of getting your capital back, certainty that you'll get distributions, and of course, we look at the yield. The question we ask is, to what degree can the underlying business support the commitments required by the security, and what yield does that justify? So, our preferred exposures in the income securities space are those securities issued by the major banks and the high quality industrials.
Grove: What sort of factors can impact the prices of these securities?
Reddy: There are quite a lot of factors; there's changes in credit spread, changes in the financial position of the issuer or P/Es, changes in regulation or legislation, corporate activity, returns you can get on alternative investments. I'll touch on, probably credit spread is a good one. A credit spread is the interest rate differential between the benchmark rates such as a government bond and a non-government security. Now credit spreads change as there's changes in actual or perceived risks. So, if a credit spread widens, it implies there is a higher risk.
Let's say with a lot of concerns about the financial stability of banks, in such a scenario we'd expect credit spreads to widen on securities issued by banks. Another way of saying that is that we'd expect prices to fall, or the yield to increase.
Grove: Finally, Ravi, where do these sorts of investments fit within a well-diversified conservative long-term portfolio?
Reddy: There are opportunities for capital gain, but the main purpose of investing in these is to get a regular income distribution stream. We suggest that they should be part of a diversified portfolio, and we also suggest that investors should seek profession investment advice before making investment in one of these securities, because they need to be aware of the risks, as we discussed before. They are not like bank deposits, they are riskier, so with a higher return you're going to have a higher risk.
Grove: Ravi, thanks very much for joining us.
Reddy: Thanks, Nick.
Grove: To learn more about investing in hybrids, Morningstar.com.au premium subscribers, can go to our website, click on the 'Hybrids' tab, and click on the link below.