Hybrids – The Marcus Today Hybrids table
After much long term nudging, I have taken the time to build a Marcus Today spreadsheet of Hybrids, convertible preference shares and capital notes. Here it is. The most recent issues are at the top and the most recent issue from each of the major issuers (mostly the Banks and Macquarie) are highlighted in orange – these are their most ‘current’ hybrids:
Hybrids. Are they shares? Well, sort of. You can deal in them like shares and they have some relationship to shares. But they’re not like normal shares.
In short they are company debt issued by companies in the share market rather than the government in the bond market.
Most of them pay you an interest rate for lending the company your money and you will be offered your money back after a period of time (redemption) although the new rort is to issue ‘perpetual’ notes, no set payback date for your dollar.
When it comes to paying you interest, each year is divided up into either two or four periods and they will pay you out two or four times a year. You have to read the PDS (product disclosure statement) of each individual instrument to know its terms, how much it pays, when, and when you get your money back and how much you get.
But it’s their names which give away the story. “Reset Preference Shares”, “Converting Preference Shares”, “Perpetual Exchangeable Resaleable Listed Securities”; sounds like shares to me and in fact, they are, because in the event the company that issues them goes bust, there is a pecking order of who gets paid and holders of most hybrids will rank behind creditors or have their ‘note’ converted to ordinary shares leaving them back at the bottom of the creditors list.
NOT A RISK-FREE BOND
The hybrid selling point is that on the face of it, to an equity investor, they look like a risk-free bond with a higher yield than a risk-free bond, with the added attraction that most of them pay quarterly. So there’s some income outside the bi-annual sweet spot between the ex and pay dates of the ordinary bank share dividends.
But hybrids obviously aren’t risk-free and the ‘perpetual’ nature of most hybrids means there is no reliable yield to maturity, no guarantee of getting your dollar back and on that basis they can trade at a significant discount to the issue price ‘in perpetuity’ as well.
Of course the standard hybrid sceptic argument is that the risk on the Hybrid is significantly higher than ‘risk-free’ and includes an element of equity risk that pure bond investors would baulk at but equity investors don’t either understand or don’t care about. All they see is a low-risk price and a yield being paid by a company that is reliable as long as that very low odds event occurs, the issuer goes bust. Laughable risk to an equity investor, who is prepared to take the risk that one of the big four banks won’t go bust for the certainty of the income that a hybrid appears to provide.
HOW IT COULD ALL GO WRONG
- Perpetual risk – As a perpetual note there is no guarantee of getting your money back. Almost all these capital note issues are now perpetual. There are ‘reset’ dates (that work in favour of the banks) but there is no end date for getting your dollar back.
- Precipitous collapse risk – When it comes to risk in Hybrids you have to know this. If there is any risk of the parent company not paying or being able to pay its dividends and hybrid distributions, the hybrid will get smashed. In the GFC hybrids held and held compared to shares, and then, like an option coming into expiry, some collapsed. In the last GFC this was apparent in CBA PERLS III as well as the AMP and Macquarie Notes. As it was this was a great buying opportunity, but it made it clear that hybrids are not risk-free, there is a significant capital risk in extreme events when confidence is lost, these things drop off a cliff. In the GFC this was a huge opportunity. Here is a chart showing the huge drop in the CBA PERLS III hybrid issue in the GFC. It fell from $200 to $130.
- Issuance risk – As some of you will have found out, when the banks start issuing a lot of hybrids the price of the existing hybrids can go down as investors sell to buy.
- Interest rate risk – Another risk (which can also be a benefit to existing holders) is that interest rates fall and the BBSW goes to zero, in which case the yield, which is floating in almost all cases, will slide away bit by bit as well. For existing holders the flipside of that is that the hybrid prices go up, as they have been doing in the recent interest rate downtrend.
- Complexity – 99 per cent of retail investors that buy a hybrid could not possibly explain their risk, the circumstances in which the hybrid they now own can be converted, redeemed, by whom and when let alone what is meant by a Capital Trigger Event or a Non-Viability Trigger Event. ASIC themselves have said that hybrids are “complex investments that even experienced investors struggle to understand” which rather leaves the unsophisticated investor at a disadvantage. In other words most investors are at a loss to describe the circumstances in which they will lose money. And this is the point, that the headline offer of a safe fully franked yield is winning the day over the cold analysis of the risk-reward ratio. Hybrids are issued via complex documents that most retail investors gloss over. To most fixed interest bond market professionals hybrids are a joke, because the risk-return profile compared to a government bond is stacked in the issuer’s favour. They would not accept the terms, but equity investors, who are used to big licks of risk, do.
- Issuer in control – If interest rates go to zero this will be expensive debt and the banks will no longer want to/be able to pay 4-5% premiums to the bank bill swap rate (BBSW). They will use their small print to re-finance and cancel them.
- Liquidity risk. Come a major market scare, if hybrids quickly fold up, which has yet to be tested, you could well run into liquidity issues, it is untested.
- A lack of independent research – Every broker will tell you how fantastic every new hybrid issue is, commission talks.
But of course all this is low risk – most hybrids do exactly what they say on the box and major disturbances are low odds. The likelihood is that you will get your 5% yield and the NAB, CBA, ANZ and WBC will not go bust.
By their nature hybrid investors are of course cautious. If that is you, and you want to be as risk-free as possible stick to the big bank issues. Don’t go down the quality curve for a higher yield…the risk rises exponentially as the issuing companies get smaller.
Latest ASX update on Hybrids
SHOULD YOU BUY HYBRIDS?
The answer is simple.
You can, but at the retail end of things (as far as private investors are concerned) hybrids only really suit people who have got enough money. You will not see any significant growth. That’s what equities are for. Hybrids are for people who do not need/want to grow/risk their capital and are so far ahead of the game that they are happy with a bit of a yield rather than growing the capital pool that generates it.
Hybrids are not for people who are not retired, they are not for people who are still building funds for retirement, and they are not for people who feel they are behind the eight ball, people that want/need to grow their capital and people that don’t earn as much income as they’d like. In other words they are not for anyone who wants to ‘have more’ and has ambitions or a need to have more money.
Hybrids are for rich people and on that basis you would never buy them in a growth portfolio. Parking money in a hybrid that provides no chance of a material capital gain is giving up on the best bits of the market. A lot of wealthy people, especially some of those that were disturbed by the GFC, have. You just have to ask yourself whether you are one of them.
The bottom line is that the worst-case scenario, a major hybrid issuer going bust is still a very very low odds event and that’s what it would take for all this hybrid criticism to matter. Until then you can almost certainly rest easy in the vast majority of existing large-cap hybrid issues.
The Golden Rules of hybrids are these:
- If there is any risk of a GFC style event you will probably get nailed so don’t fall for the “It’ll be OK in the end”, just get out.
- Stick to the major company issues. The capital risk is so acute when it does go wrong that you don’t need to play in the ‘smart arse’ small end of the hybrid market. There aren’t many of them anyway.
- If we do see a GFC style even and the major bank hybrids are down 40%…buy them!
HAS ANYBODY HAD A BAD EXPERIENCE WITH HYBRIDS?
We had a healthy Facebook discussion in July this year – 55 comments in reply to the question “Has anybody had a bad experience with Hybrids”. Here is some of the edited chatter – I was expecting a lot of “No” replies – but there were a few:
- Fear-mongering by bond market commentators is common place – the bond market is highly critical of hybrids. Self-interested corporate bond sellers would paint you as an idiot for considering hybrids. They would prefer you to buy corporate bonds and to put you off hybrids they highlight the equity risk which is alien to bond traders. But if you stick to the big end (major bank hybrids) – they simply do what they say on the box…until…something huge and unexpected happens. When it’s normal they’re great. When a GFC threatens they could, possibly, in extreme circumstances, evaporate.
- Yes – I had a terrible experience with the Allco Hybrids prior to the GFC. Ridiculous structure pushed on an unsuspecting public who had some trust in “bank hybrids” – it was a great example of when Hybrids go wrong – when the underlying company’s existence comes under threat. That’s why the MQG and AMP Hybrids fell to a big discount to par in the GFC because people really thought they might go bust – when they don’t the hybrid comes back to par (as happened) – the way to filter out (minimise) that extreme possibility is to stay high on the quality scale of the underlying issuer – which is easy to do – you stick to major bank hybrids. It will take an extreme event to upset big bank hybrids – even in the GFC when AMP and MQG hybrids fell to 60c in the dollar, they all came back to par before expiry.
- I think hybrids are incredibly dangerous, especially when marketed as “safe” investments. I lost the lot on Great Southern Plantations and Multiplex hybrids. Significant amount. Still hurting. Also, incredible correlation/contagion can happen – e.g. if one bank defaults on hybrid interest payment (or goes bust) then the knock-on effect on all other bank hybrids would be huge.
- Hybrids are seemingly great – High yield, capital gains, super returns when you get a priority holders allocation when rolled over etc. etc. BUT…if they have an event, you can lose the lot. Do not get confused about what they are, insurance for the issuer. By buying a hybrid, you are effectively writing an insurance policy for the issuer and if they have to make a claim, they are struggling financially, your policy gets called in and your hybrid turns to equity at a time when no-one wants it. They are not risk-free and the equity risk is real when things happen at the far end of the bell curve of possibility.
- Hybrids give a good return with very low volatility but their daily turnover is low and, if there were to be a major problem with any issuer…what then? You won’t be able to get out.
- The GFC certainly made me sceptical of hybrids after bad experiences with hybrids from Allco and Gunns. All went to the wall. Bank hybrids have been good though and the daddy of them all for me has been MXUPA. Bought for $18 just after the GFC and sold yesterday for $97 and never missed a payment.
- I have been in Betashares HBRD for over a year now. About 1% up in capital and about 5% income. Happy. Would buy hybrids directly but very little research out there on what to buy. An ETF looks safer. HBRD portfolio manager is Coolabah Capital. I have always been impressed by Christopher Joye’s knowledge and analysis of hybrids. I have money in HBRD to access the skills of the portfolio manager.
- There’s an animated debate here about HBRD – CLICK HERE
I’ve had a look at HBRD – this is their video – bear in mind that this is a marketing video not independent research. Actively managed (it is not a passive exposure to one asset class like a lot of ETFs) – holding 30-35 listed and unlisted hybrids is a worry to me – I reckon you can get a better return with one or two of the top quality listed hybrids if well watched for seismic “exit now” events (very rare) – plus returns are low risk enough without diversifying hybrids – do you really need a diversified ‘portfolio’ – probably not. I don’t think you need to take a “portfolio” approach. Some of the major bank hybrids in this falling interest rate environment (which is set to continue) have returned an over 20% total return in two years – that’s what you want – HBRD with its diversification has underperformed that outcome.
This is the HBRD total return chart (orange) against the All Ords (blue line) since issue – 5% return:
- I would love a hybrids portfolio much like your Top 50 portfolio. A listing of preferred hybrids. Hmmm…would be like watching paint dry.
- ASX list of hybrids – CLICK HERE
HYBRIDS DIVIDEND CALENDAR in order of pay date:
JANUARY TO JUNE
JUNE TO DECEMBER
Other income investing resources:
Did you enjoy this article?
Hear more from the Marcus Today team with a 14-day free trial