Hybrid securities and notes

Debt and equity

Hybrid securities may be issued by well-known companies, banks and insurers, but they are very different from other fixed interest investments.

Hybrid securities can expose you to 'equity-like' risks but only give you 'bond-like' returns. Some 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 type of investment that have elements of both debt and equity. They're a way for banks and companies to borrow money from investors.

Like bonds, hybrid securities typically promise to pay interest, at a fixed or floating rate until a time in the future. Unlike a bond, the amount and timing of interest payments are not guaranteed. They can also be converted into shares or your investment can be terminated at any time.

Hybrid securities can usually be traded on a secondary market such as the Australian Securities Exchange (ASX).

Warning

Hybrid securities are complex products. Even experienced investors may struggle to understand the risks involved in trading them. Don't invest in them if you don't fully understand how they work.

The risks of hybrid securities

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

Trigger events

Investment features and returns often depend on whether a 'trigger event' occurs.

Trigger events include:

  • a loss of earnings causing the deferral of interest payments
  • a change in the capital levels of the issuer resulting in a conversion to equity
  • 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 significantly affect how the investment behaves or whether you get the payments you expect. These events can be difficult to predict.

Market price volatility

Like shares, the market price of a listed hybrid security may fall below the price you paid for it. This may be more likely if the company suspends or defers interest payments, or its performance or prospects decline. Changes to the company's share price or general interest rates may affect the price of a listed hybrid security.

Liquidity risk

While most hybrids are traded on the ASX, they are often less liquid than shares. 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 security becomes insolvent, you will usually rank behind senior bondholders and other creditors. This means you'll be among the last to get your money back, if there's any left after other creditors have been paid.

Bank hybrid securities

Banks and insurers issue hybrid securities to raise money that can count as regulatory capital under the prudential standards that apply to banks and insurers.

These securities are designed to be loss absorbing, which means you, not the bank, are at risk of suffering a loss. It protects the bank's depositors, at the expense of hybrid investors.

Warning

If the bank experiences financial difficulty, hybrids can be converted into bank shares, which may be worth less than your initial investment, or written off completely, meaning you could lose all your capital.

There are three types of bank hybrid securities: capital notes, convertible preference shares and subordinated notes.

Capital notes and convertible preference shares

Capital notes and convertible preference shares are very similar. You should receive:

  • regular interest payments, sometimes called distributions or dividends
  • ordinary shares or cash on a fixed date in the future, usually in around 8-10 years; however, the issuer can do this earlier than expected.

Interest may not always be paid on capital notes and convertible preference shares and missed payments will not accumulate. However, if payments are not made, the bank can't pay dividends on its ordinary shares.

Subordinated notes

Subordinated notes are like capital notes or convertible preference shares, but with a fixed maturity date, an expectation that interest will be paid, and no scheduled conversion into shares. Interest payments and repayment of your capital have fewer conditions.

Corporate hybrid securities

Corporate hybrids, also known as subordinated notes, are high risk, complex investments where you lend money to a company in return for regular interest payments. Interest payments can be deferred for years and the company may not have to repay your capital for decades.

Corporate hybrid investors get paid last

Large companies typically borrow money from a number of sources, including banks, and by issuing wholesale bonds (only available only to professional investors). This borrowed money is referred to as 'senior debt' because, if the company becomes insolvent, these investors are the first to be repaid.

Money a company borrows from smaller investors is generally 'subordinated' to the senior debt, so corporate hybrids are called 'subordinated notes'. If the company becomes insolvent, as a subordinated note holder you will rank behind the banks, senior bondholders and other creditors, and will only get your money back if there is anything left after the senior debt holders have been paid.

Corporate hybrids may have terms that ensure interest payments to hybrid investors can only be made after interest on senior debt is paid, or they may prevent hybrid investors being repaid their principal until all senior debt is repaid or refinanced.

Check the hybrid issuer's credit risk

Always consider the credit risk of a company before investing in a corporate hybrid. Here are some things to look for in the prospectus for the hybrid offer:

  • How much senior debt does the company currently have?
  • How much money is it looking to raise by issuing hybrids?
  • Does the company generate enough cash to make payments on both senior debt and hybrids, now and in the future?
  • Are there limits on the company's ability to pay interest or repay principal to hybrids investors while it has senior debt?

Corporate hybrids can be issued by listed and unlisted companies.

Risk in hybrids issued by listed companies

Subordinated notes issued by listed companies may have the following risk factors:

  • Unsecured - Your investment is not secured by a mortgage or security over any asset.
  • Deferral of interest payments -- Interest payments can be deferred or the company may be required to do so if certain financial ratios are breached. Interest owing may be cumulative, but you'll still be temporarily out of pocket, possibly for years. The decision to hold back interest payments may cause the market price of the security to fall.
  • Long maturity dates - Investment terms can lasting decades. A 40-year-old who invests in a security with a 60-year maturity would need to live to 100 to see their investment mature. The longer the maturity, the greater chance that the company might default on its obligations or run into financial difficulties.
  • Early redemption - The company has the option to repay your investment after a fixed period, usually around 5 years after the hybrid is issued, but you do not have similar rights. In some cases, the interest rate will increase if the hybrid is not redeemed by a certain date, however this increase may be very small or not occur for a long time.

Risk in hybrids issued by unlisted companies

Unlisted companies that issue hybrid securities can have a different financial structure from listed companies. They may have more senior debt, which ranks ahead of hybrid security holders.

The risks of subordinated notes issued by unlisted companies include:

  • Second ranking security - You may benefit from the same security available to the senior lenders, but on a second ranking basis. This means that if the issuer is wound up, money from asset sales will first be used to repay senior lenders, with the real possibility that nothing will be left for hybrid investors.
  • Deferral of interest payments - Interest payments may be deferred for a wider range of trigger events, such as breaching a loan covenant contained in the terms of senior debt. Loan covenants can become stricter over time. For example, they may require the company to continue to increase its earnings at a particular rate for the life of the hybrid. This protects the senior lenders at the expense of hybrid investors.
  • Earlier maturity - Hybrid securities issued by unlisted companies often have a much shorter maturity, say 5 years; however, the company may only be able to repay you if the senior debt has been repaid or refinanced first. The company may repay your investment early, sometimes offering a small premium for doing so, but only with the agreement of the senior lenders.

What you should know before investing in a hybrid security

Make sure you fully understand the features and risks of any hybrid security before you invest. You can get these details from your financial adviser or from the prospectus. Make sure you can answer the following questions:

  • 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? Can other less complex or risky long-term investments provide a similar or better return?
  • Does the issuer have to pay interest? Do missed payments accumulate?
  • What is the maturity date? Can the issuer repay the investment early?
  • 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?

Prospectus terms explained

Here are the meanings of common terms used in hybrid security prospectuses.

  • Discretionary non-cumulative distributions - Interest payments are not guaranteed, they are paid at the discretion of the issuer. Missed payments do not accumulate.
  • Unsecured and not guaranteed - The issuer does not guarantee your investment will be repaid, and it is not secured by a mortgage or security over any asset. Unlike savings accounts or term deposits with a bank, hybrids are not covered by the Government guarantee
  • Subordinated - If the issuer becomes insolvent, and there is any money left after senior debt holders are paid, followed by all other creditors. Subordinated note holders are paid next, then capital note and convertible preference shareholders. Ordinary shareholders are paid last.
  • Scheduled conversion or mandatory conversion - Capital notes and convertible preference shares may convert into ordinary shares in the issuing company on a fixed date, usually 8-10 years after the hybrid is issued, if the issuer's ordinary share price has not fallen by more than 50% in that time.
  • Optional redemption, resale or transfer - The issuer can repay your investment (or, in some cases, convert it to ordinary shares) early if they meet certain conditions and receive regulatory approvals. This can occur on one or more fixed dates, typically beginning 6 years after the hybrid is issued, or any time there is a change to laws or regulatory requirements affecting the hybrid.
  • Redemption - The issuer must repay your investment on maturity, often many years after the hybrid is issued.
  • Early redemption - The issuer can repay your investment early, but only if they receive regulatory approval. This can occur on one or more fixed dates, typically beginning 5 years after the hybrid is issued, or at any time if there is a change to laws or regulatory requirements that affect the hybrid.
  • Perpetual - Despite a number of terms specifying when your investment can be repaid or converted into shares, capital notes and convertible preference shares have no fixed maturity, which means your investment may never be repaid.
  • Interest - This is payable at regular intervals and is not discretionary.
  • Loss absorption event - If the issuer experiences financial difficulty, they may be required to convert your investment into ordinary shares or write it off completely, meaning you could lose some or all of your investment. This could also be described as a 'capital trigger event' or a 'non-viability trigger event'.

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: 29 Oct 2018