Corporate hybrid securities

See through the familiar brands to the risks

Corporate hybrids, also known as subordinated notes, are high risk, complex investments in which an investor lends 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 hybrids can be traded on the ASX. They do not include those hybrids issued by banks and insurers, which are discussed on our bank hybrid securities webpage.

Here we explain the risks of corporate hybrids and the difference between hybrids issued by listed and unlisted companies.

Why hybrid investors get paid last

Large companies typically borrow money from different places, including directly from banks and by issuing wholesale bonds 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.

Corporate hybrids are one way for companies to borrow money from smaller investors. The money borrowed from smaller investors is generally 'subordinated' to the senior debt, and so corporate hybrids are called 'subordinated notes'.

If the company becomes insolvent, hybrid investors rank behind banks, senior bondholders and other creditors, so they will only get their money back if there is something left after the senior debt holders have been paid.

Corporate hybrids can be designed to support a company's senior debt while the company is still trading. For example the hybrid 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 credit risks to consider. You can find these in the prospectus for the hybrid offer:

  • How much senior debt does the company have and 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?

Risk in hybrids issued by listed companies

Subordinated notes issued by listed companies can include the following features, many of which are risk factors:

  • Unsecured - Your investment is not secured by a mortgage or security over any asset.
  • Deferral of interest payments - Interest payments can be stopped for a number of years. The company may have the option of deferring interest payments or it may be required to do so if certain financial ratios are breached. Interest owing may be cumulative but investors will still be temporarily out of pocket. The decision to hold back interest payments may cause the market price of the security to fall.
  • Long maturity dates - Hybrids can have investment terms lasting several decades. A 40-year-old who today 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 particular 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 a lot more existing senior debt, which ranks ahead of hybrids.

The features and risks of subordinated notes issued by unlisted companies, and how they are different from those issued by listed companies, include:

  • Second ranking security - Hybrid investors may have the benefit of the same security available to the senior lenders, but on a second ranking basis. This means that if the issuer is wound up, any realised assets 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 trigger events based on a wider range of financial ratios, such as breaching a loan covenant contained in the terms of senior debt. These 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 hybrid investors 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.

Case study: Chris and Jane are disappointed by subordinated notes

couple on computerSeveral years ago, Chris and Jane each received an inheritance of $10,000, which they invested in subordinated notes.

Chris invested his money in hybrids issued by Company A. For the first few years he received interest payments on time, but these stopped when Company A began to experience financial difficulty. Chris wants to sell his investment, but because the hybrids have stopped paying interest and improvements in Company A's financial position have been slow, the market price for his hybrids has dropped nearly 90% since they were issued.

Jane invested her money in hybrids issued by Company B. Like Chris, Jane initially received interest payments as scheduled, but these stopped when the company was placed into administration. Jane will have to wait until the senior bondholders and other creditors have been repaid before she gets any of her original investment back. She has been advised not to expect any return of her capital, which makes her investment almost worthless.

Subordinated notes may be issued by well-known brands and promise attractive returns, but they have complex features and high risks. Your interest payments can stop at any time if a trigger event occurs and you may not see even part of your capital for decades.

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Last updated: 08 Jun 2018