Hybrid Securities typically refer to securities that display both debt like and equity like characteristics.
They have been around for some 20 years, first originating in the form of listed convertible notes which paid a fixed rate of interest for a period of time before converting into a fixed number of ordinary shares on a conversion date (often subject to a floor). This meant that investors received a fixed interest like income stream until maturity then received the benefit of any capital appreciation on the underlying shares over the term.
As corporate tax laws changed, the original style convertible notes no longer became attractive for corporations to issue. Soon a new style of hybrids emerged known as Income Securities. These Securities which paid a floating rate return above the 90 day bank bill swap rate became popular at the start of this century. Examples include National Australia Bank Income Securities (NABHA) and Macquarie Bank Income Securities (MBLHB). Initially these securities appeared attractive as bank deposit rates at the time were typically at least 0.5% or more below the RBA's benchmark cash rate. (Unlike today when deposit rates are often 1% above the cash rate). Although Income Securities ranked much lower in the capital structure, some investors felt that the additional return was sufficient to compensate for the additional risk.
With the benefit of hindsight, the problem with any new style of securities issued is that potential risks cannot always be easily foreseen. The limitations of Income Securities soon became more visible when new issues came to market on more attractive terms (usually higher interest margins). Almost immediately the price of existing securities fell as investors rotated out of issues paying lower margins, leaving investors holding securities worth less than the initial face value. Even worse, the perpetual nature of these securities meant that there was no guarantee that investors would ever be able to recover the face value of these securities back unless the issuer undertook a voluntary redemption.
The problem with these securities compounded as hybrids continued to evolve. New hybrid securities began to be issued (including convertible preference shares, step up securities, mandatory converting securities, subordinated notes) at even greater margins to the bank bill swap rate, causing the prices of existing securities to fall further.
Then of course came the GFC...Investors who had thought they had purchased a low risk alternative to a fixed term deposit soon received a rude shock as the price of many hybrids fell heavily.
How to Avoid the Pitfalls
The key risks of hybrids are not generally well understood. Understanding these risks is the best way to avoid the pitfalls that can arise:
- Investors want the defensive part of their portfolio to actually be defensive
When an investor is told that an investment is a fixed interest alternative, their expectation is exactly that. They expect to receive a return higher than a term deposit without taking much more risk. Of course the problem with many hybrid securities is that they actually are not really fixed interest alternatives at all. Many are quasi-preference shares that display more equity like characteristics and therefore equity like risks. Hybrids such as reset or converting preference shares are NOT fixed interest alternatives and so should not form part of the defensive section of a portfolio.
- Credit Risk
The ability of any issuer to repay its debts as and when they fall due has always been, and remains, the paramount concern when assessing the creditworthiness of any issuer. There is nothing wrong with buying securities at the bottom of the capital structure if there is a very low risk that the issuer will default on its obligations. Similarly, there is nothing wrong with investing in a higher risk issuer if you buy securities high up in the capital structure that have a very good chance of being repaid even if the issuer goes into liquidation.
- Understanding the Capital Structure
An outline of a corporate structure is broadly as follows:
In the event that a company gets into financial difficulty, it is the secured creditor that has priority, typically via a fixed and floating charge over the assets of the company. This means the issuers of the senior secured debt have the highest probability of being repaid.
If assets remain available, a liquidator will then distribute funds to creditors in accordance with the cascading priorities. Senior unsecured creditors are next to get repaid, followed by subordinated unsecured creditors. It is rare that any funds are leftover for preference shareholders or ordinary shareholders.
It follows that investors who take on more risk should be compensated for that additional risk by way of higher returns.
Most hybrids issued fall in the lower levels of the capital structure, typically in the preference shares or subordinated debt categories. This means that the probability of a recovery in a winding up is relatively low. As a result, an assessment of credit risk is paramount.
- Avoid Hybrids that do not have a fixed maturity date, have complex conversion terms or where dividends are discretionary and non-cumulative
The value of a hybrid is equivalent to the present value of its future income stream. This value falls if the hybrid does not have a fixed maturity date. Some hybrids have call dates whereby the security can be redeemed at that date subject to meeting certain conversion terms, but if not, can become perpetual. These are best avoided.
Similarly, some hybrids have relatively complex conversion terms where it is difficult to predict the likely outcome until the actual conversion date. Further, some issuers have discretion over whether or not they pay dividends to investors. This lack of certainty reduces their relative attractiveness. These are also best avoided.
- Carefully assess those issues that contain non-viability triggers.
Basel III is a global regulatory standard on bank capital adequacy introduced to reduce the risk of bank failures that occurred during the GFC. In Australia the principal regulator for banks and insurers is the Australian Prudential Regulation Authority (APRA). APRA is responsible for overseeing compliance of the new Basel III regulations. In essence, part of the new global standards requires banks to hold more 'tier 1 capital'. A new generation of hybrids have been issued by banks as a result which include certain loss absorption or non-viability triggers. These hybrids effectively rank as preference shares, and as such rank ahead of ordinary shares in the event of a wind up situation but junior to other unsecured creditors. However, if a nonviability clause is triggered (e.g. Tier 1 capital falls below 5.125% or issuer gets into financial distress), then the preference shares lose their priority and instead convert into ordinary shares (under a formula that most likely would result in holders receiving considerably less than the equivalent original face value) and rank alongside ordinary shareholders in a wind up. This means that the preference shares effectively have the same security as an ordinary shareholder and so should be viewed as an equity instrument rather than as a valid fixed interest alternative. As a result investors need to carefully assess whether the return provided adequately compensates them for the risk of buying the securities.
Conclusion
Hybrid securities can be complex instruments but when risks are well understood, they can play an important role in a diversified portfolio. Like all investments, it is imperative that investors assess whether the potential returns adequately compensate for the relative risk undertaken.
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