Hybrid securities

by Ben Power | 09 Jan 2013

There’s always a risk when it comes to monetary investment. We show you how to get the most out of your SMSF by turning to hybrid securities and fixed income products.

After the GFC-triggered stock market crash, retirees have increasingly focussed on fixed income products that provide more stable capital and income, as well as portfolio diversification. Many are turning to hybrid securities. 

There is debate about the exact definition of hybrids, but generally they have both equity and debt characteristics and are listed on the ASX. Typically they earn higher yields than the likes of term deposits, but they’re less risky than shares.

Assets sit in a capital structure, which effectively means blocks sitting on top of each other. The higher the block, the riskier the asset. Hybrids sit above cash and government bonds, but beneath equity.

Hybrids and you

Hybrids have a role to play in some retirees’ portfolios. They provide diversification, good yields and can be used to time future income needs. But each hybrid is different. 

“Each security has its own specific terms and conditions,” says Ravi Reddy, equities analyst at Morningstar. “You only have to look at the size of some of the prospectuses to realise how complicated they can be.”

Regulatory changes also mean hybrids are starting to look increasingly like equity, with investors having fewer rights to get their money back in difficult times. That might mean retirees investing in hybrids to diversify and hold more defensive fixed income assets are actually not spreading their risk to the extent they think.

Benefits to retirees

Hybrids are typically issued at a face value of $100 and a coupon, the current Bank Bill Swap Rate plus a margin, is paid between two and four times a year. When the principal is redeemed it can come as cash or as shares of the issuer, though particular perpetual notes have no redemption date.

Hybrids are attractive to retirees because they have higher yields. While yields on term deposits are currently just over five per cent, investors can earn double-digit returns from hybrids. According to research firm Morningstar, the BBSW rate, which is currently 3.5 per cent, plus a three per cent margin, are fair returns for a median-risk hybrid.

Provenance Corporate and Personal Advice’s Paul Banner says he includes hybrids in portfolios, along with cash, generic bonds, international bonds, high-quality blue chip shares, and riskier growth assets, such as infrastructure and international shares.

Banner primarily uses hybrids to meet future income needs. He’ll time hybrids’ maturities, when investors get their money back, with future income requirements. “I look to have the maturity profile to match the pension income liability,” he says.

Banner says the value of the funds at the call date of hybrids is more certain than managed funds, which can be hit by interest rate movements, just when the retiree needs to access the funds.

Risky business

But hybrids can be risky. The investor may not be paid if a company gets into difficulties. In 2008 for example, the collapse of Allco Finance saw investors lose a total of $250 million invested in hybrids issued by the company.  

The key, Banner says, is to assess the risk of a hybrid issuer, and compare it with the hybrids yield and alternative assets.

“The critical point for me is the risk that I am taking on by holding the hybrid relative to the return I’m getting,” Banner says. “I then compare that to the less risky option: a term deposit.”

Unfortunately, there is a trend for hybrids to have more equity-like characteristics. “You’ve got an entire spectrum,” Banner says. “There are products that in my mind should be categorised as an equity piece where the risk of default and risk of capital loss are equally as high as it would be for an equity.” 

Details, details, details

Retirees need to be aware that, when it comes to hybrids, the devil is in the detail, and they need to focus on risk as much as reward. 

As to what portion of a portfolio should be dedicated to hybrids, each portfolio should be customised to reflect the investor’s preferences and their risk profiles. 

Banner says retirees’ portfolios usually lean towards defensive assets, but for a portfolio with half defensive assets and half growth assets, of the defensive portion, about 20 per cent might be hybrids, with the other 30 per cent in term deposits or other fixed interest investments.