Tips for Exposure into Hybrid Securities

Hybrid Securities have been acting as a shelter for income-savvy investors due to usually high-income paying attributes. A Hybrid Security has characteristics of equity and debt securities, and usually pay a relatively higher rate of return that could be fixed or floating.

A higher rate than the debt securities gives Hybrid Securities features like equity investments, and these securities have inherent risks like equity. There are three main types of Hybrid investments.

Convertible Debt: Convertible Debt is a debt instrument with an option to convert the holdings into ordinary equity.

Preferred Equity: Preferred shares are like equity investments with no voting features, but these shares have preference over the ordinary equity shares with respect to dividends or distributions.

Capital Notes: Capital Notes have debt and equity like features having a perpetual feature, which means no maturity. These securities are redeemed by the issuer under defined conditions.

Why investors prefer Hybrids?

Investors favour investments in Hybrid Securities due to high income attributes, thus there exists risks in such securities that are compensated by a higher rate of return as compared to bonds or equities.

Investors choose these securities because of the periodic and pre-determined income, the diversification benefits offered by such investments. Rate of returns in Hybrids is usually better than bank deposits.

Australian investors have developed liking for the Hybrids due to the attractive franked income distributions provided by these securities. At the same time, Hybrids could vary from issuer to issuer, meaning that the proposition to the investors would not be the same with every Hybrid on exchange.

A lack of understanding of Hybrid instruments could pose risks for the investors as they could inherit unintended risk due to lack of understanding.

Hybrids securities have been becoming an important part of Banks’ capital structure. Post the global financial crisis, the new regulations introduced by the banking regulators led to massive increase issuance of Hybrid securities to meet the capital requirements.

Hybrid Securities on ASX

Mainly there are two types of Hybrids on ASX.

Corporate Hybrids: These Hybrids are issued by companies other than Banks. Issuers of this type of Hybrid could be an unlisted as well as a listed entity. These instruments provide the corporates with an ability to borrow money from a whole set of investors on an exchange, including retail investors.

Bank Hybrids: Banking companies float Hybrid Securities to meet the capital requirements formulated by the regulator or to fund business operations, among other reasons. The Australian Prudential Regulatory Authority (APRA) has guidelines on which Hybrids could be treated as regulatory capital, including Tier 1 or 2 Bank Hybrids.

Tier 1 Bank Hybrids do not have a fixed maturity, and these securities have convertibility feature into ordinary equity on a predetermined date depending upon the condition enlisted by the issuer. However, Tier 2 Bank Hybrids have a defined maturity date.

Banks may need to convert these Hybrids into ordinary equity shares in the event of its regulatory capital falling below the levels demanded by the regulator. Tier 1 Hybrids are converted initially in such events, after which Tier 2 Hybrids are converted into ordinary equity shares.

Managing risks associated with Hybrid Securities

Risk management is vital in managing your investments, and it is highly favourable to understand the degree of risks associated with investments and its impact on the expected rate of return.

It is known that asset classes with potentially higher returns come with higher risks and vice versa. Hybrids Securities have a higher rate of returns because these securities have a higher level of risks too.

The volatility in the security prices generally measures risks, and Hybrids could have greater volatility due to the bonds and equity like features associated with these securities as market prices of Hybrids could be volatile during different market scenarios.

Liquidity Risk: ASX has many Hybrid securities having complex and idiosyncratic features with some being illiquid as well. An investor should consider investing in liquid securities having decent trading volumes, which would shield from the permanent loss of capital.

Liquidity of the securities is dependent on the risks associated with the business, issue size, creditworthiness, listed or unlisted and outlook of the business.

Credit Risk: Credit risk arises when the borrower is unable to service the interest payments on the principle of the securities. It is the main risk associated with fixed-income instruments. Hybrid securities are associated with credit risks, and the cash flows of the business are crucial for making interest payments.

Volatility: As Hybrids have equity like features, the market prices of Hybrid Securities could fall below the price that was paid at the time of purchase. Business performance and potential risks to the business could be a defining factor in the price movements of Hybrid Securities.

Ranking: Hybrids are usually unsecured instruments with no collateral backing, which means that the repayment of the capital is not backed assets that could be liquidated at the time of default. In cases when a company becomes insolvent, Hybrid investors rank behind the bondholders of the business, thus they are ranked after the bondholder in repayment at the time of insolvency.

Deferral of coupon payments: Companies often have clauses that enable to suspend the interest payments on the Hybrid Securities, but the interest payments are accumulated and paid on a later date. Deferral could pose cash flow risks for the investors and make the securities vulnerable to volatility.

Termination: Some Hybrids also provide the issuer with an ability to repay the principal amount at an early date, which may leave the investors with less returns.

Bottomline

Investing in Hybrid Securities appears reasonable in a low-interest rate environment wherein quality issuers pay a low interest on highly ranked securities. Since highly-rated issuers are always in the high demand, the yields on securities issued by highly-rated issuers could be very low and even negative in some cases.

Hybrids enable an investor to generate a higher yield from the investments. However, an investor in these securities should carefully consider the inherent risks associated with them, which may result in permanent loss of capital.

Moreover, there should be extensive due diligence prior to investing in any securities, and it applies to Hybrid Securities as well.

Disclaimer