Hybrid securities and notes
Consider the features and risks
Hybrid securities (including subordinated notes, capital notes
and convertible preference shares) may be from well-known
companies, banks and insurers but they are very different from
other fixed interest investments.
Some hybrid securities make investors take on 'equity-like'
risks but only give them at best, 'bond-like' returns. Some have
terms and conditions that allow the issuer to exit the deal or
suspend interest payments when they choose. Others may convert into
ordinary shares, or be written off completely if the issuer
experiences financial difficulty.
Hybrid securities may not be suitable for you if you need steady
returns or capital security.
What are hybrid
Hybrid securities are a way for banks and companies to borrow
money from investors in return for interest payments. They are
offered by well known companies and blend some of the features of
debt (fixed interest) and equity (shares).
Each investment will differ in terms of conditions, timeframe and
interest rates. They are generally traded on a secondary market
such as the ASX.
Types of hybrid securities
While all companies issuing hybrids are borrowing money from
investors, the terms and features of the investment will vary
depending on who issues the hybrid.
Here are webpages that give more details about hybrids offered by
Hybrid securities are complex products. Even experienced
investors will struggle to understand the risks involved in trading
them. If you don't fully understand how they work, you should
The risks of hybrid
Hybrid securities have higher risks than other types of
corporate bonds. Here are some of the most common risks.
Hybrid investment features and returns often depend on whether
or not a certain 'trigger event' occurs.
These trigger events could include:
- A loss of earnings causing the deferral of interest
- A change in tax laws or regulatory requirements which may give
the company the right to repay the hybrid early or much later than
The issuing company may have limited control over these trigger
events but they can have a significant impact on how the hybrid
behaves or whether you get the payments you expect. They can also
be very difficult for investors to predict.
Case study: Arthur's travel plans get derailed
Arthur has just turned 60, and is reducing his
hours at work. In addition to his super, he has saved $30,000,
which is set aside for a well-deserved overseas holiday when he
retires at 65. Until then, he would like to invest the money to
earn regular interest, but keep it safe for his big trip in 5
Attracted by a promised interest rate several percentage points
higher than the rate his bank offers on a term deposit, Arthur
invests in hybrids issued by PowerCo. They have a legal maturity of
25 years, but Arthur reads a broker report that focuses heavily on
the 'first call date', saying that PowerCo is expected to repay the
hybrids after 5 years.
For the first year of his investment, Arthur is pleased with the
higher interest payments he receives, but becomes concerned when
PowerCo announces a loss for the second year, and predicts lower
earnings in the future.
Three months later, PowerCo announces that its weaker financial
position has caused a 'trigger event' under the hybrid terms, which
allows PowerCo to defer interest payments.
While he can get by without the interest payments, Arthur is now
worried about getting his money back, as PowerCo doesn't have to
repay the hybrids for 25 years. Because of its weaker financial
position the market price for PowerCo's hybrids has dropped, so if
Arthur sells them now he will suffer a large loss.
Market price volatility
Like company shares, the market price of listed hybrid
securities may fall below the price that the investor originally
paid, especially if the company suspends or defers interest
payments, or if its performance or prospects decline. Changes in
the company's share price and in other interest rates may also be
reflected in the price of the listed hybrid security.
While most hybrids are traded on the ASX, they are often less
liquid than shares in the company that issued them. This means that
there are fewer buyers and sellers in the market for this type of
investment and if you need to exit your investment in a hurry, you
may have to accept a lower price.
Hybrid securities are generally unsecured, meaning that
repayment is not secured over an asset. If the company issuing the
hybrid securities becomes insolvent, hybrid investors generally
rank behind senior bondholders and other creditors. This means they
are among the last to get their money back, if there's any left
after other creditors have been paid.
Case study: Katie's subordinated notes down
Katie lends money to Company A by buying
subordinated notes with a $100 face value (purchase price), 40
years until maturity and paying 8% per annum yield ($8). At the
time, the official interest rate in the market is 4%. In order to
attract investors to its riskier subordinated notes, Company A pays
an extra 4%, or 8% in total.
The perceived risk of Katie's subordinated notes increases,
because something happens that makes the market think Company A is
more likely to default. New investors may demand a higher annual
yield of 9% in order to invest in a similar investment. Company A's
'credit spread' has moved from 4% to 5% above the official interest
The $8 annual income Katie is getting is less than the $9 she
could now be getting from another investment with similar risks.
This impacts on the market price of Katie's subordinated notes,
which reduces by 11% (from $100 to $89).*
While demand and supply for the subordinated notes can also
affect its market price, Katie could potentially lose 11% due to
the 1% change in yield, which is caused by a re-evaluation of
Company A's creditworthiness.
Comparing hybrids to
Hybrids combine both 'equity like' and 'debt like'
features. Some will behave more like shares, and some more
like corporate bonds. When comparing hybrids to other investments,
consider which features are better suited to your personal
circumstances, and whether the promised return fairly compensates
you for the additional risks involved.
Here we compare the features of a capital note issued by a bank
and a subordinated note issued by a company, to shares, corporate
bonds and bank term deposits.
- Shares -You may receive dividends which are
paid at the company's discretion. They do not accumulate if not
- Capital notes - You may receive distributions
based on a set formula, but these are at the bank's discretion and
do not accumulate if unpaid. If the bank does not pay distributions
on capital notes it can't pay dividends on its ordinary
- Subordinated notes -You are entitled to
receive interest payments based on a set formula. Interest may be
deferred (and accumulate) for up to 5 years depending on the
issuing company's financial position.
- Corporate bonds - You will receive interest
payments that are either fixed or based on a set formula.
- Term deposits - You will receive interest
payments based on a fixed rate.
Investment timeframe and redemption
- Shares - Shares have no maturity date, and are
never required to be repaid.
- Capital notes - Fixed period of generally 8-10
years. They are designed to convert into ordinary shares, however
if the bank meets certain conditions, it may choose to repay the
capital notes in cash or delay the conversion.
- Subordinated notes - Fixed term of up to 60
years from the date of issue. You will be repaid in cash at
- Corporate bonds - Fixed term, usually between
5 and 10 years from the date of issue. You will be repaid in cash
- Term deposits - Fixed term, usually between 1
month and 5 years. You will be repaid in cash at maturity.
Early repayment at the issuer's discretion
- Shares - No.
- Capital notes - Yes, subject to certain
conditions and regulatory approvals after 5 or 6 years, or at any
time if a relevant trigger event occurs. You may be issued with
ordinary shares in the bank instead of cash.
- Subordinated notes - Yes, on fixed dates
usually beginning 5 years after the note was issued, or at any time
if a relevant trigger event occurs.
- Corporate bonds - Yes, but only in limited
- Term deposits - No.
Early repayment at the investor's discretion
- Shares -Yes, listed shares can be sold on a
stock exchange at the current market price.
- Capital notes, subordinated notes and corporate
bonds - These investments are usually listed and can be
sold at the current market price, subject to market liquidity. This
could mean that if you need to sell your investment in a hurry, you
may have to accept a lower price if there are fewer buyers in the
- Term deposits - Yes, although you may forfeit
some or all of the accrued interest.
- Shares - If there are any assets left after
repaying all banks, lenders and bondholders, shareholders divide up
what is left, but they are the last in line.
- Capital notes - Before the bank becomes
insolvent, a 'loss absorption' or 'non-viability' event will occur.
Your capital notes will either convert into ordinary shares in the
bank, which may be worth significantly less than your original
investment, or be written off completely.
- Subordinated notes - If there is anything left
after bank lenders, senior and secured creditors and other
bondholders have been repaid, you may get some or all of your
- Corporate bonds - If there are any assets left
after bank lenders, senior and secured creditors are repaid, you
are the next in line to be repaid some or all of your investment,
ahead of any subordinated note holders.
- Term deposits - Term deposits placed in an
Authorised Deposit-taking Institution of up to $250,000, are guaranteed by the Government. This
cap applies per person and per ADI.
Questions to ask
You should make sure you fully understand the features and risks
of any particular investment in hybrid securities before committing
Here are some questions you should be able to answer before you
invest. You can get these details from your financial adviser or
from the prospectus.
- What are the risks of investing in this hybrid security, now
and in the future?
- Will the returns offered adequately compensate for the
- How does the interest rate compare with other investments on a
'risk adjusted' basis? Can other less complex, risky or long-term
investments provide a similar or better return?
- Does the issuer have to pay interest? If they don't, do missed
- What is the maturity date? Can the issuer repay the investment
early, or leave the hybrid on issue for a very long time?
- Are there any trigger events (such as 'loss absorption' or
'non-viability') where your hybrid may convert into ordinary
shares, or be written off completely?
- Will this product help you achieve your personal goals and
objectives, and does it suit your investment timeframe and personal
- Can you exit this investment if your circumstances change?
To check your understanding of hybrids, take the MoneySmart
Some hybrid securities are high risk
investments. Make sure you fully understand these complex products
before investing your hard earned cash.
Last updated: 18 Jan 2018