Hybrid securities are widely held by self-managed super funds (SMSFs) but not necessarily well understood beyond the issuer identity and the quoted rate of return. Hybrids can enhance returns to a portfolio and provide another level of diversification but investors should make themselves aware of their unique characteristics before making assumptions about the risk and rewards involved.
A hybrid is the commonly used name to describe a security that combines elements of a debt security, such as a bond, with an equity security, such as a share – hence their name. However this combination of features mean that while the return is enhanced so is the risk.
Hybrids may include conditions around the suspension of payments under certain conditions and the conversion of the hybrid into equity (shares). Additionally the hybrid could be terminated early, for example if interest rates fall. In the event the issuing company goes into receivership, hybrids holders will be paid after the holders of debt (if there are funds left) but before shareholders.
SMSFs are significant holders of the hybrids that are issued by the major banks and insurance companies. These are acquired either through the initial offering or via the secondary market that is traded on the ASX.
CommSec data also shows that these products are more heavily skewed toward those SMSFs who are of retirement age and may be looking for a higher return potential over cash, term deposits and bonds.
As mentioned, hybrids can achieve a higher return than debt through an exposure to a higher level of risk.
There are three main risks to consider when investing in hybrids.
The first is interest rate risk. This mainly applies to hybrids with fixed interest payments. If rates rise, the value of these instruments will fall to the level where the fixed payment approximates the new yield available in the market. That is, it exhibits characteristics of a fixed rate bond.
The second risk is credit risk - the risk that the issuer will not be able to meet the promised payments. It also includes a credit spread risk, where investors demand a higher spread (over Government bond rates) for securities because of an expected deterioration in economic or industry conditions.
The final risk is liquidity, or marketability, risk. That is the risk of not being able to sell your investment quickly or easily at a fair price because of either a lack of market demand or a major credit event. An example of this occurred during the Global Financial Crisis (GFC). It is worth noting that even under normal circumstances, hybrids are relatively illiquid in comparison to the share market and that the buy/sell spread can be quite high and vary greatly on a day to day basis. This is where the retail investor can be at a disadvantage to professional fund managers.
In addition, hybrids can often contain complex features not readily understood by retail investors and variations between seemingly similar instruments can be hard to discern from the prospectus or PDS. It is recommended that if you have doubts, you should seek financial advice. For convertible hybrid securities, where the price of the underlying security (usually the ordinary share of the issuer) can trigger a conversion of the hybrid to ordinary shares, the price of the hybrid in the market may fall as the price of the ordinary share falls.
Advantages of Hybrids for SMSFs
Given many SMSFs are buying direct equities to derive retirement income and accepting the greater volatility that entails, hybrids exhibit much less volatility in price than shares, especially since the GFC.
SMSFs in retirement phase potentially might have a heavy weighting to cash and equities, and hybrids may help diversify a portfolio allowing access to an income stream (for a pre-determined period) with higher return over cash with some hybrids also entitling SMSFs access to franking credits. A truly diversified portfolio needs a spread across other asset classes, and hybrids can play a part in the diversification process.
To reduce interest rate risk - especially important if you believe the next movement in rates is likely to be up - many hybrids pay an interest rate that is floating rather than fixed, which can make them less volatile than fixed rate debt and offer a hedge against inflation.
Recently a new actively managed Australian hybrid ETF has been launched. For the retail investor the advantages of this approach is a greater level of diversification of issuers, a higher level of liquidity due to the presence of a market maker and risk management due to its active nature using a professional manager.
Hybrids are popular with SMSFs for good reason. They generally pay better returns than term deposits, may offer franking credits and tend to be less volatile than shares. In addition SMSFs are comfortable in knowing that many of their most widely held hybrids are those issued by the same financial institutions whose ordinary shares they hold.
As always when investing in new products or changing investment strategies seeking good financial advice is important. For more information investors can refer to the ASX publication Understanding Hybrid Securities, an attractive alternative for income (1) or call CommSec Advisory to discuss hybrid opportunities.
(1) “Understanding Hybrid Securities, an attractive alternative for income”, ASX Limited. 2016