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 securities?

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 different issuers:

Warning

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 not invest.

The risks of hybrid securities

Hybrid securities have higher risks than other types of corporate bonds.  Here are some of the most common risks.

Trigger events

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 payments
  • A change in tax laws or regulatory requirements which may give the company the right to repay the hybrid early or much later than expected

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

man on phoneArthur 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 years' time.

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.

Liquidity risk

While most hybrids are traded on 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.

Subordinated ranking

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 rate.
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.

* This calculation is based on the present value of future cash flows. The $11 loss today is equal to the 1% increase from 8% to 9% over the 40 years. This doesn't consider the valuation of options that may be embedded in the subordinated notes or other rate 'step up' features also found in some hybrid securities.

Comparing hybrids to other investments

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.

Investment income

  • Shares -You may receive dividends which are paid at the company's discretion. They do not accumulate if not paid.
  • 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 shares.
  • 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.
  • Subordinated notes - Fixed term of up to 60 years from the date of issue. You will be repaid in cash at maturity.
  • Corporate bonds - Fixed term, usually between 5 and 10 years from the date of issue. You will be repaid in cash at maturity.
  • 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 circumstances.
  • 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 market.
  • Term deposits - Yes, although you may forfeit some or all of the accrued interest.

Insolvency

  • 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 investment back.
  • 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 your money.

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 investment risk?
  • 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 payments accumulate?
  • 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 risk profile?
  • Can you exit this investment if your circumstances change?

To check your understanding of hybrids, take the MoneySmart hybrids quiz.

Some hybrid securities are high risk investments. Make sure you fully understand these complex products before investing your hard earned cash.


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Last updated: 03 Feb 2014

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