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Hybrids

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What are hybrids?

Hybrids are a broad classification for a group of securities, used by a range of corporations to raise money, that combine both debt and equity characteristics. They are usually higher risk investments than other fixed income securities due to their subordination in the capital structure, but generally lower risk than shares (equities), see the figure below. Other characteristics include:

• Hybrids pay a predetermined (fixed or floating) rate of return or dividend until a certain date. At that date the holder may have a number of options including converting the securities into the underlying ordinary share of the issuer
• Therefore, unlike a share the holder has a 'known' cash flow and, unlike a fixed interest security, there is an option held by the issuer to convert to the underlying equity
• Hybrid securities have a wide variety of maturities, structures and varying liquidity as well as issuers across the credit rating spectrum. Since every hybrid is structured differently this allows more flexibility, but makes analysis and comparison more difficult
• Hybrids usually offer higher returns than those offered by more senior assets in the capital structure such as senior and subordinated debt.

In Australia, the major banks are large issuers of these types of securities. Hybrid securities keep evolving. There are five types of hybrids securities currently available, which are outlined below.

1. Income Notes and Securities are true perpetual securities, that is, they have no maturity date or a very long maturity. These securities usually pay floating rate coupons and while the issuer normally has the option to call (i.e., redeem them for their face value) on any payment date it is unlikely they will ever be redeemed. Income Notes and Securities examples: Bendigo Bank (BENHB), Macquarie Group (MBLHB), National Australia Bank (NABHA) and Suncorp Metway (SUNHB).
2. Reset Preference Shares are typically fixed rate preference shares where the coupon is set for a defined term, normally five years. At the end of the five year period, the preference shares are remarketed where they are either redeemed or a new fixed coupon rate is set. They are technically perpetual in nature. Reset Preference Shares include: Bendigo Bank RPS (BENPA), Bank of Queensland (BOQPA), IAG Reset Preference Shares 1 (IAGPA and, Suncorp Metway RPS (SUNPA).
3. Converting Preference Shares are preference shares that convert into the ordinary shares of the issuer after a defined period of time assuming certain conditions occur. Most converting preference shares offer the option for the issuer to redeem them for cash, however equity conversion is usually the default option. They are technically perpetual in nature. Converting Preference Share include: ANZ (ANZPA & ANZPB), Westpac (WBCPA & WBCPB) and Commonwealth Bank PERLS 4 & 5 (CBAPB & CBAPA)
4. Step up Preference Shares are the most common type of corporate hybrid. These preference shares normally pay a floating rate coupon and have a call date after a set period, normally five years. If these securities aren't called at the first call date, then the coupons 'step up' to a higher rate to compensate investors for non-redemption. They are technically perpetual in nature. Step up Preference Share include: Elders SPS (ELDPA), Fairfax SPS (FXJPB), Goodman Plus (GMPPA), Orica SPS (ORIPB) and Woolworth's Notes (WOWHB).
5. Stepped up Preference Shares are step up preference shares that have already passed the step up date and pay a higher coupon over and above the original coupon. They are perpetual in nature although the issuer has the option to call the securities on any future coupon payment date. Stepped up Preference Share include: Australand Assets Trust (AAZPB) and Gunns Limited (GNSPA).

What are some of the key risks to investors?

The two main risks when investing in hybrids are:

• Credit risk: The risk that an issuer may be unable to meet the interest or capital repayments on the hybrid when they fall due. Generally, the higher the credit risk of the issuer, the higher the interest rate that investors will expect in order to risk lending funds to the issuer.

  Hybrids are riskier than bonds (both senior and subordinated debt) in a liquidation scenario. However, in most cases they are less risky than equity (shares). The order in which repayment to investors is made after liquidation of the issuer is demonstrated by the (corporate) capital structure diagram below.

• Interest rate risk: The risk associated with an interest bearing asset, such as a hybrid, due to variability of interest rates. Price s of hybrids will vary for many reasons, one of them is a change in interest rates. In general, as rates fall, the price of a hybrid will rise, and vice versa. This creates the likelihood of a capital gain or loss in the event the holder needs to sell the hybrid prior to maturity. Similarly with floating rate notes, if market sentiment towards the issuer changes, the premium paid by the issuer over the benchmark known as the "spread" will change from the issuing premium.

Common terms:

Call date – The date prior to maturity on which a callable bond may be redeemed by the issuer. If the issuer determines there is a benefit to refinancing the issue, the bond may be redeemed on the call date, at par, or at a small premium to par depending on the terms of the call option.

Fixed or floating coupons – The coupon rate can be fixed or floating for the term of the security. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day bank bill rate. A fixed rate coupon is set at the time the bond is issued and remains the same over the life of the bond. The coupon rate is set by the issuer based on a number of factors including prevailing market interest rates and its credit rating. Fixed rate bonds in Australia predominantly pay a semi-annual coupon whereas floating rate bonds predominantly pay a quarterly coupon. Indexed linked bonds usually pay quarterly coupons.

Perpetual – A security with regular periodic payments for an infinite number of periods with no maturity date.

Running Yield – The interest rate on an investment expressed as a percentage of the capital invested. It takes no account of the capital accumulated. It is used to describe the income investors receive from their portfolio as a percentage of market value of the securities.

Yield to Maturity – Represents the return an investor would receive if a bond was purchased and held to maturity. Yield to maturity is considered the most important variable of bond analysis because it provides a basis for comparison between different securities and other interest rate products.

Yield Curve – The yield curve shows the relationship between interest rates and term to maturity. In other words, the yield curve is the market's current view of interest rates for various terms to maturity.