Bank hybrid securities
Big risk without a big return
Hybrid securities issued by banks and insurers, known as bank
hybrids, may sound like a safe investment, but they are much more
complex than a savings account or term deposit. They are listed on
ASX but they are not the same as investing in the bank's ordinary
shares.
Here we explain the features and risks of the three types of
bank hybrid securities: capital notes, convertible preference
shares and subordinated notes.
The risks of bank hybrid
securities
Banks and insurers issue hybrids to raise money that can count
as regulatory capital under the prudential standards that apply to
banks and insurers.
All new hybrids issued by banks and insurers are designed to be
loss absorbing, which means you, not the bank, are at risk of
suffering a loss. This protects the bank's depositors, at the
expense of hybrid investors.
Warning
If the bank experiences financial difficulty, bank hybrids can
be converted into bank shares, which may be worth less than your
initial investment, or even written off completely, meaning you
could lose all of your capital.
What are 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. On a fixed date, around 8-10
years in the future, you should receive ordinary shares in the bank
that issued the hybrid, although they may decide to repay you in
cash.
These hybrids can behave very differently depending on a range
of factors that are outside your control. The terms often contain a
complex series of events, tests, conditions and approvals that even
experienced investors can find difficult to understand.
You may not get payments
Interest may not always be paid on capital notes and convertible
preference shares and missed payments will not accumulate. Although
if payments are not made, the bank is prevented from paying
dividends on its ordinary shares. Your investment may convert into
ordinary shares instead of being repaid in cash, and this may occur
years before or after the scheduled date.
Prospectus terms explained
Here are the meanings of common terms used in capital note and
convertible preference share 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 unlike savings
accounts or term deposits with a bank, hybrids are not covered by
the Government guarantee. Your investment is not
secured by a mortgage or security over any asset.
- Subordinated - If the issuer becomes
insolvent, investors in capital notes and convertible preference
shares are the second last group to be repaid if there is any money
left. You will rank behind all other creditors but ahead of
ordinary shareholders.
- Scheduled conversion or mandatory conversion -
The hybrid will convert into ordinary shares in the issuer on a
fixed date, usually 8-10 years after the hybrid is issued, provided
that 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.
- 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.
- Loss absorption - 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 is often
described as a 'loss absorption event', a 'capital trigger event'
or a 'non-viability trigger event'.
What are
subordinated notes?
Subordinated notes issued by banks and insurers have very
different features and risks to those issued by other companies.
They are more 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.
Prospectus terms explained
Here are the meanings of common terms used in subordinated note
prospectuses.
- Unsecured and not guaranteed - The issuer does
not guarantee your investment will be repaid, and unlike savings
accounts or term deposits with a bank, hybrids are not covered by
the Government guarantee. Your investment is not
secured by a mortgage or security over any asset.
- Subordinated - If the issuer becomes
insolvent, you will rank behind senior debt holders and other
creditors for a return of any capital, but rank ahead of capital
note and convertible preference shareholders.
- Interest - This is payable at regular
intervals and is not discretionary.
- Redemption - The issuer must repay your
investment on maturity, often 10 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.
- Loss absorption - 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.
Case study: Daniel weighs up the risk and return of
capital notes

Daniel has $20,000 in a term deposit with BIG Bank. When it
matures, he is offered a rate of 4.5% if he reinvests his money for
a further 12 months.
He has seen a story on a news website about a new capital note
being offered by BIG Bank, which promises to pay 6%, so he
downloads a copy of the prospectus.
Reading through the prospectus, Daniel is surprised to learn
that if BIG Bank experiences a 'loss absorption event', his capital
notes will automatically convert into ordinary shares in BIG Bank.
These shares may also be worth much less than his initial
investment because a complex formula limits the number of shares he
can receive.
While Daniel doesn't think BIG Bank is going to fall over any
time soon, he's not prepared to take the chance and invest in their
capital notes. His term deposit is government guaranteed, and he
doesn't think it is worth all that complexity and risk for an extra
1.5%.
Capital notes, convertible preference shares and
subordinated notes are complex investments. While they are issued
by banks and insurers, they are very different to a savings account
or term deposit.
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Last updated: 29 Mar 2018