Reality #7 Hybrids have traditionally been part debt and part equity. Since 1 January 2013 under new Basel III regulation, bank hybrid issues have become much more like equity, and do not provide the same level of protection as bank bonds in a downturn
That’s why it’s important to own a range of fixed income investments including low risk bonds that have more stable prices in a distressed market compared to hybrids.
Hybrids can miss paying interest and can have long terms until maturity
Hybrid distributions can be missed and never paid to you, making investment in hybrids higher risk than deposits and bonds. If you are investing in hybrids for the income, then it’s important to be aware of this risk.
Most bank hybrids are perpetual, meaning they have no fixed maturity date and if not exchanged or redeemed, could remain on issue indefinitely. A requirement of bank and insurance regulators, such as APRA, is that these securities must be perpetual and must be able to absorb losses on a going concern basis (that is, coupons can be foregone without payment and are non-cumulative) and at the point of non-viability (conversion into common equity or write-off), in order to qualify as regulatory capital.
Just three corporate hybrids remain on the ASX – Multiplex, Nufarm and Ramsay Healthcare, all three are perpetual, which means you have to sell them to get your capital back.
Hybrids typically contain clauses with call or conversion dates before final maturity but there are usually conditions attached and the dates are by no means guaranteed with the power in the hands of the issuer.
On the other hand, bonds and deposits have known interest payment and maturity dates, which if not met are an event of default.
Hybrids have all of the downside risk of shares, without the upside. Bonds offer greater certainty you’ll be paid your interest and principal. Subordinated bank bonds like hybrids, can also convert to shares in certain circumstances
Our research shows that hybrids are much more volatile in price than bonds and are more likely to track the underlying share when markets are distressed as the graph below comparing three Commonwealth bank investments demonstrates.
The purpose of the graph is to show a worst case scenario and the volatility the various investments showed during a crisis.
We invest $100 on the 29 December 2007 and then track performance throughout the global financial crisis. The red line shows the value of major bank senior bonds, the green, the Perls III hybrid and blue, the CBA shares. The returns shown include interest payments on bonds, distributions on the hybrids and dividend payments on shares, as well as franking credits.
The senior bond line shows a fairly gradual upward trend increasing in value. The GFC does not impact its value, enabling investors to sell if needed and recoup their capital. The returns are stable and consistent, in fact boring, but in bond investment we think “boring is good” as it is what protects your portfolio. In this example the senior bond line is a composite of the “Big 4” banks and not just the CBA given that senior bank bonds generally are only issued for five years and the graph is over a longer period.
The hybrid, being higher risk than the bond, shows increasing volatility. In the worst case scenario, an investor selling in March 2009, would have lost approximately 30% of their capital. The hybrid recovers somewhat, but does not catch the lower risk bond in terms of return.
The shares show the most volatility as they are considered highest risk, falling over 50%. But, notice how the hybrid declines like the share and loses 30% of its value. If your fixed income allocation is 100% hybrids, we think you are taking on too much risk in your portfolio and not providing enough of a hedge against your shares.
I think of CBA as being the lowest risk company on the ASX. The other major banks are also low risk but if you only own bank hybrids, we’d expect all of them to perform in a similar fashion under stressed market conditions.
Managers of large investment funds know the best way to combat uncertainty and to protect capital and income is to diversify investments. Replacing some of your hybrids with lower risk bonds will help to lower the risk and improve diversification in your portfolio.