Investors looking to receive a steady stream of income have often only considered bank term deposits but hybrid securities can offer a higher level of return with higher levels of risk.
What are Hybrids?
Interest rate securities - also known as hybrids - are exchange-traded instruments that combine some of the features of equity securities with some of the features of debt securities. Typically, they more closely resemble a debt instrument at the time of issuance, but may convert into equity at a pre-determined time in the future, or if certain conditions are satisfied. It is important to understand that not all instruments have the same terms and conditions, therefore careful consideration of each security is recommended.Ord Minnett offers accessible, plain language summaries of key terms for each security under research coverage.
Nuts & Bolts of Hybrids
Discover the world of Hybrid Securities
There are many reasons investors may choose to invest in hybrid securities, including the potential to:
- receive an income stream for a pre-determined period, although the certainty of cash flows varies depending upon the hybrid structure
- improve the return on your capital
- vary the risk profile of your overall portfolio
- profit from anticipated movements in interest rates or equity prices
- utilise the franking credits attached to distributions on hybrids
Hybrids combine both 'equity like' and 'debt like' features. Some of the comparisons to shares and bonds include:
- Accessibility: Hybrid securities can be sold on the secondary market. Investors can also reinvest existing holdings or purchase securities when an issuer launches new money offers.
- Steady income stream: Shares pay dividends at the company’s discretion. Similarly, distributions on hybrids are made at the discretion of the issuer.
- Investment timeframe: Like bonds, hybrid securities are typically issued with scheduled call dates, but generally these securities can be left to trade into perpetuity or may be converted to ordinary shares in some circumstances.
- Early redemption: Like bonds, a hybrid issuer may elect to repay the security by repaying the principal or converting the hybrids to ordinary shares.
- Subordination: In a wind-up scenario, holders of hybrid securities will only be repaid once lenders, bondholders or other higher-ranked securities are repaid. Hybrids typically only rank above the ordinary shares of the issuer.
There is a higher level of risk associated with hybrid securities when compared to a regular bond, term deposit or fixed interest investment. The conditions, timeframe, risks and return of each hybrid security will differ and some may have complex features.
- Complexity: While most hybrid securities are structurally similar, it is important to understand that each security contains features that are complex and may impact the value of the security.
- Conversion: Under certain circumstances, issuers may convert hybrids to ordinary shares which may in some instances see the investor receive less than their initial investment.
- Credit risk: The risk that the issuer may default on its payment obligation. Higher credit risk requires a higher return to investors to compensate investors for the increased probability of expected losses. In most instances, distributions are discretionary and the issuer has the ability to stop making distributions and it may not constitute a default event.
- Deferral of distributions: Issuers in most instances reserve the right to defer or cease the payment of distributions on a security. This can adversely impact the price of the security and expected income.
- Interest rate risk: Hybrid securities typically pay a fixed margin above the bank bill swap rate (BBSW). If BBSW declines, this could reduce the expected income over time.
- Liquidity risk: Hybrid securities are typically less liquid than ordinary shares of the underlying issuer.
- Market price volatility: Like shares, the market price of a hybrid security will fluctuate in response to changes in market conditions.
- Subordination: Hybrids are unsecured credit, meaning they rank behind senior bondholders and other creditors in a wind-up scenario.
- Term risk: The security may remain outstanding for shorter or longer than expected. Issuers may have the ability to terminate the investment early, but may not extend that same right to the investors. On the other hand, some hybrids may have investment terms lasting several decades and can withhold repayment until maturity if their financial position deteriorates.
Interest rate securities can be a valuable addition to a portfolio where, for example, volatility in the equity market has increased an investor’s level of risk aversion. Alternatively, conservative investors grappling with low interest rates can incrementally improve expected returns by incorporating interest rate securities in their strategy.
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