Hybrids: What you need to know

James Brooks
March 2012

Hybrids: What you need to know

March 2012

Introduction
Hybrids are a fixed income style security that typically incorporates a slightly higher level of risk to that of a term deposit or government bond. They combine the characteristics of interest rate securities and equity capital. Depending on the needs of the issuer, hybrids may incorporate a more debt like bias or have more equity like features, depending on the needs of the issuing company. These varying characteristics will have an impact on the performance of the instrument over the life of the security.

Hybrids place on the capital structure

Typically, a hybrid will rank above ordinary equity and provide a regular cash flow (like fixed income). However, unlike senior debt securities, the income from hybrids may be withdrawn or deferred at the issuers discretion and the hybrid instrument ranks below senior debt securities in the capital structure of the issuing company (Fig.1). Hybrids also contain equity characteristics by offering an option to convert the hybrid into an underlying equity when a particular event occurs (e.g. at maturity or following a change of control).
Fig.1. Corporate Structure and Risk Ratings

Security
Lowest Risk

Category
Debt

Product
Commonwealth and State government bonds Corporate Bonds Corporate Bonds Hybrid Securities Hybrid Securities Hybrid Securities Ordinary shares

Common Name
Treasury Fixed Coupon Bonds and Treasury Capital Indexed Bonds Senior-debt secured Unsecured Subordinated debt Perpetual step-up securities (cumulative) Perpetual step-up securities (non-cumulative) Converting preference shares Perpetual preference shares Ordinary shares
Source: Bell Potter

Debt Lower Tier 2 Upper Tier 2 Innovative Tier 1 Non-innovative Residual Tier 1 Highest Risk Fundamental Tier 1

Hybrids: What you need to know

March 2012

Risks
It is too often assumed that hybrid securities are risk-free, which is not the case. Hybrid securities rank on the capital structure as higher risk that that of term deposits or government bonds and are therefore susceptible to credit risks. In addition to these, investors also need to take into the consideration the interest rate, liquidity and early redemption risks associated with the hybrid market (Fig.2). It is therefore imperative for investors to carry out the necessary due diligence before investing into the hybrid market, formulating an outlook for interest rates and researching the credit and financial health of the issuer in particular.
Fig.2. Types of risks to the hybrid market

Type of Risk

Description Credit risk refers to the fact that the issuer may not be able to pay its obligations (distributions or capital). As can be seen in the corporate structure (Fig.1) the greater the rewards, the higher the risk that needs to be undertaken. It is therefore important before purchasing a hybrid security to conduct diligent credit and financial health analysis on the issuer. An investors outlook for interest rates will have a major bearing on the attractiveness of the hybrid market and specific securities. Fixed rate securities will typically outperform in a declining rate environment as the distribution remains resilient. Floating rate securities are marked at a margin above a risk-free rate and therefore these will decline with interest rates. Although the hybrid market is liquid, it is not as liquid as that of the equity markets for instance. The risk therefore with some of specific securities is that it may not be possible to sell out when desired or needed, due to the fact there are not sufficient buyers. There is a risk that the issuer could redeem based on variety of reasons, such as a movement in interest rates, default, a potential take-over or a listing of the parent company to name but a few.

Credit

Interest Rate

Liquidity

Early Redemption

Hybrids: What you need to know

March 2012

Advantages/Disadvantages
Hybrids are attractive because they offer returns that are typically higher than those of term deposits or government bonds, but are also less risky than equities. Through the varying maturities and structures, investors can build a diversified portfolio of hybrids. From a tax perspective, depending on the individual issue, the investor may also be in a position to benefit through fully franked distributions. However, there are also drawbacks to hybrids. For defensive-minded investors seeking the absolute safety of fixed income, hybrids are more risky. In addition, because the rates are typically floating, cash flows can vary and in some cases, may actually be deferred. Whilst liquidity is not usually a cause for concern, there are some issues which may lack the desired level of liquidity for some investors.
Fig.3. Summary of advantages and disadvantages of hybrids

Characteristics
RISK

Advantages Lower risk offering than that of equities Typically higher than senior debt of the issuing company, reflecting the higher associated risks Hybrids rank ahead of ordinary shareholders Wide range of issuers, maturities and structures Fixed rate hybrids lock in cash flow during periods of deflation and lower interest rates Opportunity to participate in the company through the share conversion option Potential Tax benefits through fully franked distributions

Disadvantages Higher risk than term deposits or government bonds Typically lower than equities due to the inherent lower risk

RETURNS

STRUCTURE FEATURES & LIQUIDITY

Hybrids rank below debt holders

Varying liquidity Majority of hybrids are floating rates so lower interest rates will equal lower cash flow Perpetual in that may only be redeemed either at the issuers option or if certain conditions have been satisfied

INTEREST RATES

CONVERSION / REDEMPTION

TAX

Hybrids: What you need to know

March 2012

Types of Hybrids
Hybrid securities differ in terms of the obligations, maturity dates, conversion criteria and rates. There are five types of hybrids; Income Securities Perpetual Floating Rate Notes; Convertible Preference Shares; Reset Preference Shares; Step-up Preference Shares; Mandatory Preference Shares. Each of these needs to be considered separately and researched to identify the risks involved, most notably; credit risks, interest rate risks, liquidity risk and early redemption risk.
Fig.4. Overview of the types of hybrids

Type Income Securities Perpetual Floating Rate Notes

Description Perpetual debt obligations, with no specified maturity date. Investors generally have no right to require the Issuer to redeem or repay the investment. Preferred shares that on a specified date, convert into a number of ordinary shares based on a predetermined ratio. In the majority of cases, there is no cash option available and holders have no rights other than to receiving the equity conversion. Reset Preference Shares (RPS) typically pays a fixed rate where the coupon is set for a defined term. At the end of the defined term, the securities are remarketed where they are either redeemed or a new fixed coupon is set. They are usually perpetual in nature. Step-up preference shares normally pay a floating rate coupon and have a call date after a set period. If these securities are not called at the first call date, then the coupon steps-up to a higher rate to compensate investors for non-redemption/ They are usually perpetual in nature. These rank as preferred securities and ensures the issuer must convert the security into ordinary shares or redeem for cash on a certain date, but only if mandatory conditions are met. If these conditions are not met, the issuer may seek redemption for cash.

Convertible Preference Shares

Reset Preference Shares

Step-up Preference Shares

Mandatory Preference Shares

Hybrids: What you need to know

March 2012

Conclusion
As can be drawn from the research documented above, the key features of hybrids are: They pay a predetermined distribution (fixed or floating) at regular intervals, so the investor believes they have a known cash flow. However, depending on the structure and future interest rates movements, this cash flow can fluctuate and in a worst case scenario, can also be halted. At the conversion date, holders may have different options, such as; converting the securities into the underlying ordinary shares of the issuer or receiving the repayment of the original capital at par value. The maturities and structures across each hybrid differs, something investors need to be aware of in order to diversify the term and risk. On the face of it, hybrids offer higher returns than more senior securities due to their position in the capital structure. Distributions paid may offer franking credits.

The features should ensure that investors are aware of the risks associated with the hybrids market, most notably the credit, interest rate, liquidity and early redemption risks. In order to mitigate these risks as best they can, investors need to form an outlook on interest rates and ensure the issuer has sound credit credentials and the hybrid itself is liquid. Having conducted the appropriate research, investors should be in a position to identify which type of hybrid securities in particular may be most suited to their portfolio (i.e. fixed or floating rate) or if indeed the reward/risk characteristics warrant any position at all.

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General advice disclosure Any recommendation given in this document is General Advice only. We have not considered clients personal or individual circumstances. All clients and readers should seek professional advice before acting on any recommendation. You should also obtain a copy of and consider the Product Disclosure Statements for any product discussed before making any decision.

Hybrids: What you need to know

March 2012