Tuesday 19 April 2016 by FIIG Securities liz aus article 19 april Opinion

Bank hybrids - There's no such thing as a free lunch

Bank hybrids pay significantly more than term deposits for good reason. In this article, FIIG expert Elizabeth Moran explains the risks and benefits of this popular asset class

There are many ways you can invest in banks, the most common being deposits and shares. 
But with very low deposit rates and recent substantial share price falls, investors have also been increasingly attracted to hybrids offering much higher returns.
Currently a five year major bank term deposit is offering a 3.1 per cent per annum return, while the closest hybrid in terms of expected maturity date is the Westpac Capital Notes III showing an unfranked yield of 5.0 per cent per annum but if you can claim franking, this rises to 7.14 per cent per annum.
That’s roughly a 4 per cent per annum extra benefit over term deposits assuming you can claim the franking, but what additional risks are you taking for those higher returns? More importantly, do you think the 4 per cent premium is enough?
The greatest difference is that a deposit up to the value of $250,000 per entity per financial institution is government guaranteed. If anything happens to the bank and it can’t pay you back your term deposit capital at maturity, the government will step in and make the payment. This is what we would call a ‘zero risk’ investment. Aside from Commonwealth government bonds, very few investments offer this significant benefit.
The main benefit of hybrids is higher income, but there are risks that investors need to be aware of.
New style bank hybrids contain a clause which states they are ‘non-cumulative’ meaning interest payments can be foregone and never have to be made up. This is not so good for investors wanting reliable income in retirement. There can be some powerful protection for hybrid investors against this clause, and that is a “dividend stopper” clause. Banks cannot forego interest income on hybrids and still pay dividends on shares. 
You can imagine the impact on the value of bank shares if it failed to pay a dividend! However, while unlikely, it is not impossible as demonstrated by the significant, ongoing losses and complicated, government bailout of British bank, Royal Bank of Scotland.

The bigger difference and thus risk between the two investments, term deposits and hybrids, is how and when you get repaid. 
Deposit investors will have a range of fixed options depending on the type of account. For example a term deposit will repay cash at maturity. The downside though, is that long dated term deposits are not tradeable and you are locked in with no chance of any capital appreciation. 
Hybrids have a range of possibilities that are hard to quantify for professionals, let alone Mum and Dad investors.
The best possible outcome is that the hybrids convert to shares, which investors can then sell, or are repaid at the first call (optional redemption) date. 
If the bank misses first call, and possible subsequent calls the hybrids may become perpetual, that is have no maturity date. Investors then need to sell and meet the market to recoup capital. Any failure to meet a call by a bank would see a sharp decline in the hybrid’s price.
In assessing the possible alternatives it’s worth keeping in mind that hybrids are specifically designed to be ‘loss absorbing’. If the bank gets into trouble, the hybrids are there to help bail them out, and avoid the government and taxpayers stepping in. In that way they have all the downside risk of shares but none of the potential upside in higher dividends or share prices.
The worst case scenario, which is remote, is the one where the bank becomes distressed. The regulator steps in and forces conversion to shares, at a time when prices are dropping fast. The value of your investment would decline dramatically. 
To provide the full picture of possible bank investments it is worth looking at what major bank senior and subordinated bonds and shares are offering per annum over a similar five year term. Senior bonds are trading at 3.3 per cent, subordinated bonds 4.75 per cent, and dividend yields on the shares range from 5.6 to 7.6 per cent without franking.
The bonds have known maturity dates like deposits while shares have no maturity and are perpetual. You have to sell them to get your capital back. 
Looking at the range of risks and returns from all available bank investments gives you better perspective. I’ll let you decide if hybrid premiums are enough to compensate for the extra risk over deposits.