Download Hybrids: What you need to know

Hybrids:
What you need to know
James Brooks
March 2012
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Hybrids: What you need to know
March 2012
Introduction
Hybrids are a fixed income style security that typically incorporates a slightly higher level of risk to that of a
term deposit or government bond. They combine the characteristics of interest rate securities and equity
capital. Depending on the needs of the issuer, hybrids may incorporate a more debt like bias or have more
equity like features, depending on the needs of the issuing company. These varying characteristics will have
an impact on the performance of the instrument over the life of the security.
Hybrids place on the capital structure
Typically, a hybrid will rank above ordinary equity and provide a regular cash flow (like fixed income).
However, unlike senior debt securities, the income from hybrids may be withdrawn or deferred at the
issuer’s discretion and the hybrid instrument ranks below senior debt securities in the capital structure of
the issuing company (Fig.1). Hybrids also contain equity characteristics by offering an option to convert the
hybrid into an underlying equity when a particular event occurs (e.g. at maturity or following a change of
control).
Fig.1. Corporate Structure and Risk Ratings
Security
Category
Product
Common Name
Lowest Risk
Debt
Commonwealth and State
government bonds
Treasury Fixed Coupon
Bonds and Treasury Capital
Indexed Bonds
Debt
Corporate Bonds
Senior-debt secured
Unsecured
Lower Tier 2
Corporate Bonds
Subordinated debt
Upper Tier 2
Hybrid Securities
Perpetual step-up securities
(cumulative)
Innovative Tier 1
Hybrid Securities
Perpetual step-up securities
(non-cumulative)
Non-innovative
Residual Tier 1
Hybrid Securities
Converting preference shares
Perpetual preference shares
Fundamental Tier 1
Ordinary shares
Ordinary shares
Highest Risk
Source: Bell Potter
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Hybrids: What you need to know
March 2012
Risks
It is too often assumed that hybrid securities are “risk-free”, which is not the case. Hybrid securities rank on
the capital structure as higher risk that that of term deposits or government bonds and are therefore
susceptible to credit risks. In addition to these, investors also need to take into the consideration the
interest rate, liquidity and early redemption risks associated with the hybrid market (Fig.2).
It is therefore imperative for investors to carry out the necessary due diligence before investing into the
hybrid market, formulating an outlook for interest rates and researching the credit and financial health of
the issuer in particular.
Fig.2. Types of risks to the hybrid market
Type of Risk
Description
Credit
Credit risk refers to the fact that the issuer may not be able to pay
its obligations (distributions or capital). As can be seen in the
corporate structure (Fig.1) the greater the rewards, the higher the
risk that needs to be undertaken. It is therefore important before
purchasing a hybrid security to conduct diligent credit and financial
health analysis on the issuer.
Interest Rate
An investor’s outlook for interest rates will have a major bearing on
the attractiveness of the hybrid market and specific securities.
Fixed rate securities will typically outperform in a declining rate
environment as the distribution remains resilient. Floating rate
securities are marked at a margin above a risk-free rate and
therefore these will decline with interest rates.
Liquidity
Although the hybrid market is liquid, it is not as liquid as that of the
equity markets for instance. The risk therefore with some of
specific securities is that it may not be possible to sell out when
desired or needed, due to the fact there are not sufficient buyers.
Early Redemption
There is a risk that the issuer could redeem based on variety of
reasons, such as a movement in interest rates, default, a potential
take-over or a listing of the parent company to name but a few.
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Hybrids: What you need to know
March 2012
Advantages/Disadvantages
Hybrids are attractive because they offer returns that are typically higher than those of term deposits or
government bonds, but are also less risky than equities. Through the varying maturities and structures,
investors can build a diversified portfolio of hybrids. From a tax perspective, depending on the individual
issue, the investor may also be in a position to benefit through fully franked distributions.
However, there are also drawbacks to hybrids. For defensive-minded investors seeking the absolute safety
of fixed income, hybrids are more risky. In addition, because the rates are typically floating, cash flows can
vary and in some cases, may actually be deferred. Whilst liquidity is not usually a cause for concern, there
are some issues which may lack the desired level of liquidity for some investors.
Fig.3. Summary of advantages and disadvantages of hybrids
Characteristics
Advantages
Disadvantages
Lower risk offering than that of
equities
Higher risk than term deposits or
government bonds
Typically higher than senior debt
of the issuing company, reflecting
the higher associated risks
Typically lower than equities
due to the inherent lower risk
STRUCTURE
Hybrids rank ahead of ordinary
shareholders
Hybrids rank below debt holders
FEATURES &
LIQUIDITY
Wide range of issuers, maturities
and structures
Varying liquidity
INTEREST RATES
Fixed rate hybrids lock in cash
flow during periods of deflation
and lower interest rates
Majority of hybrids are floating
rates so lower interest rates will
equal lower cash flow
CONVERSION /
REDEMPTION
Opportunity to participate in the
company through the share
conversion option
Perpetual in that may only be
redeemed either at the issuers
option or if certain conditions
have been satisfied
RISK
RETURNS
TAX
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Potential Tax benefits through
fully franked distributions
Hybrids: What you need to know
March 2012
Types of Hybrids
Hybrid securities differ in terms of the obligations, maturity dates, conversion criteria and rates. There are
five types of hybrids; Income Securities – Perpetual Floating Rate Notes; Convertible Preference Shares;
Reset Preference Shares; Step-up Preference Shares; Mandatory Preference Shares. Each of these needs to
be considered separately and researched to identify the risks involved, most notably; credit risks, interest
rate risks, liquidity risk and early redemption risk.
Fig.4. Overview of the types of hybrids
Type
Description
Income Securities –
Perpetual Floating
Rate Notes
Perpetual debt obligations, with no specified maturity date.
Investors generally have no right to require the Issuer to redeem or
repay the investment.
Convertible
Preference Shares
Preferred shares that on a specified date, convert into a number of
ordinary shares based on a predetermined ratio. In the majority of
cases, there is no cash option available and holders have no rights
other than to receiving the equity conversion.
Reset Preference
Shares
Reset Preference Shares (RPS) typically pays a fixed rate where the
coupon is set for a defined term. At the end of the defined term,
the securities are remarketed where they are either redeemed or a
new fixed coupon is set. They are usually perpetual in nature.
Step-up Preference
Shares
Step-up preference shares normally pay a floating rate coupon and
have a call date after a set period. If these securities are not called
at the first call date, then the coupon “steps-up” to a higher rate to
compensate investors for non-redemption/ They are usually
perpetual in nature.
Mandatory
Preference Shares
These rank as preferred securities and ensures the issuer must
convert the security into ordinary shares or redeem for cash on a
certain date, but only if mandatory conditions are met. If these
conditions are not met, the issuer may seek redemption for cash.
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Hybrids: What you need to know
March 2012
Conclusion
As can be drawn from the research documented above, the key features of hybrids are:




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They pay a predetermined distribution (fixed or floating) at regular intervals, so the investor
believes they have a known cash flow. However, depending on the structure and future interest
rates movements, this cash flow can fluctuate and in a worst case scenario, can also be halted.
At the conversion date, holders may have different options, such as; converting the securities into
the underlying ordinary shares of the issuer or receiving the repayment of the original capital at par
value.
The maturities and structures across each hybrid differs, something investors need to be aware of
in order to diversify the term and risk.
On the face of it, hybrids offer higher returns than more senior securities due to their position in
the capital structure.
Distributions paid may offer franking credits.
The features should ensure that investors are aware of the risks associated with the hybrids market, most
notably the credit, interest rate, liquidity and early redemption risks. In order to mitigate these risks as best
they can, investors need to form an outlook on interest rates and ensure the issuer has sound credit
credentials and the hybrid itself is liquid.
Having conducted the appropriate research, investors should be in a position to identify which type of
hybrid securities in particular may be most suited to their portfolio (i.e. fixed or floating rate) or if indeed
the reward/risk characteristics warrant any position at all.
Sornem Private Wealth
AFSL 383 169, ABN 89 145 903 840
Level 1, 360 Little Collins Street
Melbourne, Victoria 3000
Australia
T + 61 3 9903 7800
F + 61 3 9903 7810
www.sornemprivate.com.au
www.unconventional-wisdom.com.au
General advice disclosure
Any recommendation given in this document is General Advice only. We have not considered clients’
personal or individual circumstances. All clients and readers should seek professional advice before acting on
any recommendation. You should also obtain a copy of and consider the Product Disclosure Statements for
any product discussed before making any decision.
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Hybrids: What you need to know
March 2012