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Hybrid Securities - Franc Mark Sterling

Hybrid Securities

Hybrid securities may be issued by well-known companies, banks and insurers, but they are very different from other fixed interest investments.  Hybrid securities can expose you to ‘equity-like’ risks but only give you ‘bond-like’ returns. Some allow the issuer to exit the deal or suspend interest payments when they choose. Others may convert into ordinary shares, or be written off completely, if the issuer experiences financial difficulty.  Hybrid securities may not be suitable for you if you need steady returns or capital security.

What are Hybrid Securities?

Hybrid securities are a type of investment that have elements of both debt and equity. They’re a way for banks and companies to borrow money from investors.  Like bonds, hybrid securities typically promise to pay interest, at a fixed or floating rate until a time in the future. Unlike a bond, the amount and timing of interest payments are not guaranteed. They can also be converted into shares or your investment can be terminated at any time.  Hybrid securities can usually be traded on a secondary market such as the Australian Securities Exchange (ASX).

The Risks of Hybrid Securities

Hybrid securities have higher risks than other types of debt investments.  Here are some of the most common risks.

Trigger Events

Investment features and returns often depend on whether a ‘trigger event’ occurs.

Trigger events include:

  • a loss of earnings causing the deferral of interest payments
  • a change in the capital levels of the issuer resulting in a conversion to equity
  • a change in tax laws or regulatory requirements which may give the company the right to repay the hybrid early or much later than expected.

The issuing company may have limited control over these trigger events, but they can significantly affect how the investment behaves or whether you get the payments you expect. These events can be difficult to predict.

Market Price Volatility

Like shares, the market price of a listed hybrid security may fall below the price you paid for it. This may be more likely if the company suspends or defers interest payments, or its performance or prospects decline. Changes to the company’s share price or general interest rates may affect the price of a listed hybrid security.

Liquidity Risk

While most hybrids are traded on the ASX, they are often less liquid than shares. This means that there are fewer buyers and sellers in the market for this type of investment and if you need to exit your investment in a hurry, you may have to accept a lower price.

Subordinated Ranking

Hybrid securities are generally unsecured, meaning that repayment is not secured over an asset. If the company issuing the security becomes insolvent, you will usually rank behind senior bondholders and other creditors. This means you’ll be among the last to get your money back, if there’s any left after other creditors have been paid.

Bank Hybrid Securities

Banks and insurers issue hybrid securities to raise money that can count as regulatory capital under the prudential standards that apply to banks and insurers.

These securities are designed to be loss absorbing, which means you, not the bank, are at risk of suffering a loss. It protects the bank’s depositors, at the expense of hybrid investors.

There are three types of bank hybrid securities: capital notes, convertible preference shares and subordinated notes.

Capital Notes And Convertible Preference Shares

Capital notes and convertible preference shares are very similar. You should receive:

  • regular interest payments, sometimes called distributions or dividends
  • ordinary shares or cash on a fixed date in the future, usually in around 8-10 years; however, the issuer can do this earlier than expected.

Interest may not always be paid on capital notes and convertible preference shares and missed payments will not accumulate. However, if payments are not made, the bank can’t pay dividends on its ordinary shares.

Subordinated Notes

Subordinated notes are like capital notes or convertible preference shares, but with a fixed maturity date, an expectation that interest will be paid, and no scheduled conversion into shares. Interest payments and repayment of your capital have fewer conditions.

Corporate Hybrid Securities

Corporate hybrids, also known as subordinated notes, are high risk, complex investments where you lend money to a company in return for regular interest payments. Interest payments can be deferred for years and the company may not have to repay your capital for decades.

Corporate Hybrid Investors Get Paid Last

Large companies typically borrow money from a number of sources, including banks, and by issuing wholesale bonds (only available to professional investors). This borrowed money is referred to as ‘senior debt’ because, if the company becomes insolvent, these investors are the first to be repaid.

Money a company borrows from smaller investors is generally ‘subordinated’ to the senior debt, so corporate hybrids are called ‘subordinated notes’. If the company becomes insolvent, as a subordinated note holder you will rank behind the banks, senior bondholders and other creditors, and will only get your money back if there is anything left after the senior debt holders have been paid.

Corporate hybrids may have terms that ensure interest payments to hybrid investors can only be made after interest on senior debt is paid, or they may prevent hybrid investors being repaid their principal until all senior debt is repaid or refinanced.

Check the Hybrid Issuer’s Credit Risk

Always consider the credit risk of a company before investing in a corporate hybrid. Here are some things to look for in the prospectus for the hybrid offer:

  • How much senior debt does the company currently have?
  • How much money is it looking to raise by issuing hybrids?
  • Does the company generate enough cash to make payments on both senior debt and hybrids, now and in the future?
  • Are there limits on the company’s ability to pay interest or repay principal to hybrids investors while it has senior debt?

Please contact your financial adviser if you wish to find out more about hybrid securities and how to invest into hybrid securities.

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Source: Australian Securities & Investments Commission, Money Smart, December 2018.

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