Hybrids – where do they fit in client portfolios?

With characteristics of both debt and equity, hybrids have traditionally been seen as providing a relatively defensive income stream, at interest rates higher than bank term deposits. For the right clients, this presents an opportunity to diversify their portfolios, however it’s important to understand how the flexible structure of individual hybrid issues may affect investment returns.

The highly structured nature of hybrids

Whether its preference shares, subordinated notes or the more familiar convertible bond, the structure of hybrids are determined by the issuer to best manage their cost of capital and diversify their funding. This mean hybrids are often highly structured with a fixed or floating rate of return just one of the ways one hybrid can vary from the next. The inclusion of franking credits, cumulative or non-cumulative, the timeframe of conversion to equity (if at all) and interest rates are more ways hybrids offer choice to investors. How hybrids are structured, in turn, affect the extent to which they behave more like equity or debt and even how this changes over time.

Recognising that the conversion of hybrids into equity is entirely at the option of the issuer or regulator, is most important when applying them to your clients’ portfolios. This unpredictability brings in extra risk considerations when deciding the extent to which hybrids are used as fixed interest securities in the asset allocation mix of your clients’ portfolios.

The ability to be influenced by the price movements of the stock into which they’re convertible means that, from a risk perspective, hybrids sit above equity and below senior debt in the capital structure as shown below.

corporate capital structure

Source: F11G Securities

Hybrids in portfolios

As hybrids may be converted at the issuers’ discretion, clients may find themselves unexpectedly holding equity securities, when they were expecting to receive an interest payment income stream. Further, this conversion may happen in times of market volatility or downturn, meaning the hybrid does not meet the investment objectives of fixed income securities of protecting portfolios and achieving yield.

Given the equity-like risks that are present within hybrids, it’s important to consider whether they are a suitable as part of the fixed income allocation. In many instances, it may be more suitable to sit a percentage of the hybrids within the ‘other’ component of a client’s portfolio in spite of the fact that hybrids can offer the best yields in the marketplace.

However, if the investor is in a position to endure the capital volatility and assuming the banks, or other issuers, were not in severe financial distress and the investor is able to hold the hybrid to maturity, there is an argument for a greater fixed interest like allocation.

Diversifying hybrids

As with all investments diversification within hybrids is important. Here are some things to consider:

  • Diversify across issuer (ie corporates and banks)
  • Diversify across maturities ( ie 1,3,5 & 7 year expiry etc)
  • Diversify some hybrid into subordinated debt or bonds
  • Diversify from banks, corporates the client already has direct shareholdings in or term deposits with.

Conclusion

Hybrids are attractive to some retail investors because they offer a yield premium for their risk levels, partly as – in many cases – they are benefitting from existence of franking credits.

When selecting hybrids advisers should be aware of the different features and assess each hybrid individually to create a portfolio that minimises the risk to capital, while still being able to receive income.

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The Pursuit Select investment menu has been bolstered with the addition of 33 new hybrid securities to its investment menu. These securities are available for you to trade in immediately. To learn more about Pursuit Select’s expanded investment menu or its enhanced online trading capabilities, please speak to your local IOOF BDM.

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Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.