Hybrids: The devil in the detail
The recent resurgence of the issuance of hybrid securities (hybrids) – securities which combine equity and debt characteristics – is providing further investment opportunities for those investors who are looking for ‘income-based’ investments and additional portfolio yield. In the 2012 calendar year to date, there has been around $5 billion of new hybrids issued as companies have looked to other options (other than issuing equity) as part of their capital management program.
Given the income characteristics of hybrids, the demand for such investments is not surprising, considering the changes we are witnessing in the market. However, investors need to focus on much more than just the ‘headline yield’ of the hybrid, as the structure and nature of hybrids is complex. Accordingly, tail risk to hybrids is significant with the devil in the detail of any offer.
As a starting point, all investments carry risk. Accordingly, investors need to exercise caution and conduct appropriate analysis before making investment decisions. In the case of hybrids this is even more the case, as hybrids are not homogenous securities.
Hybrids are often structured differently, with each having their own terms and conditions – all of which can impact the return to investors over time and the level of risk that the hybrid contributes to an investment portfolio. Therefore, in our view hybrids perform like debt when equity markets perform well, and perform like equity when equity markets perform poorly.
Hybrid securities are complex capital instruments issued by companies to diversify their funding base and manage their cost of capital. Hybrids possess characteristics of both debt and equity, and incorporate various features that may make them more ‘debt-like’ or more ‘equity-like’. Depending on the characteristics of hybrids, this will impact both the performance of the income and capital return components of the underlying security.
Hybrid securities have been promoted as investments that offer stable and defensive income streams. However, unlike senior debt securities, the income on hybrids can be deferrable and hybrid instruments rank below senior debt securities in the capital structure of a company, which makes them riskier investments, akin to holding equity.
As an example, during the worst of the global financial crisis, the income yield provided by many hybrid securities failed to offset the substantial decline in capital values. This period highlighted the downside correlation of hybrid securities to equities. This correlation demonstrates that hybrid securities are not a substitute for traditional sovereign based fixed income as the income paid by hybrids is less certain, and dependant on the viability of the issuer company, while the principal value has often been shown to be volatile, akin to holding equity.
So what are the main considerations for investors when considering a hybrid investment? In our view, there are four main issues that investors need to consider before making an investment into hybrids.
Firstly, when considering any investment it’s important to understand the expected risk reward trade-off. For hybrids, understanding where they fit (or rank) in the capital structure of a company is particularly important for investors in the advent of a wind-up of the company. As the chart below highlights, hybrids rank only one notch above ordinary equity holders.
Effectively, those investments that rank higher in the capital structure (such as senior or subordinated debt) have priority claim over cashflows and assets in a liquidation scenario. Where hybrids rank (as well as understanding the debt/equity mix of a company) is important as it may impact on the ability of a company to make its coupon payments, as well as the recovery value to investors if the company defaults.
Secondly, while the current yields on hybrids look attractive to both cash rates, term deposits and other fixed income investments, it is important to note that hybrids should not be viewed as a substitute for any of these investments. Under the terms of many hybrids, the payment of ‘income’ to investors can vary, be suspended or deferred, and may not be cumulative in nature should the company defer payment.
As part of including some level of income protection to hybrid investors, companies can also include ‘dividend stoppers’ as part of any offer. Dividend stoppers are a feature where if a company misses its income payment, it cannot pay an equity dividend. Without such dividend stoppers as part of the hybrid offer, the risk to investors by holding hybrids increases materially.
Under the new regulatory guidelines, hybrids now generally have very long maturities (up to 25 years and longer in some circumstances). However, a common feature for hybrids is that they have a ‘call date’ after a shorter time period – in many cases, five years. The feature of the call date allows the company to redeem the asset. From an investor’s perspective, the call date is an important aspect in understanding the risk and term of the security.
However, not all call dates are mandatory. In this instance, where a company does defer ‘calling’ the security it will pay a ‘step-up margin’. The step-up margin provides additional income to the investors for holding the security until either the next call date or maturity. As part of any due diligence process, it is important to understand the extent of the step-up margin to ensure it adequately compensates investors for the underlying risk of holding the security.
Equally, some hybrids may have built-in ‘trigger dates’ for mandatory conversion. Trigger dates often result in the hybrid being converted to ordinary shares at an earlier date. Again, before investing in any hybrid, understanding both the trigger dates and what would constitute mandatory conversion is an important element of the overall risks associated with hybrids.
Thirdly, when investing in a hybrid, the importance of understanding the fundamental drivers and characteristics of the issuer company is also critical. While hybrids are often used to provide for the capital management needs of a company, the skill, track record, experience and competency of company management and the industry dynamics can provide additional and valuable information as to the overall risk of holding the hybrid.
For many corporates, the information that defines the overall creditworthiness and risk of the business is often highlighted by its credit rating. The credit rating of the issuer highlights the probability that the company will default on its debt obligations. Accordingly, as many hybrids are listed investments, with a par value of $100, should the company experience periods of stress that may impact on its credit position, this is likely to also impact negatively on the (price) value of the hybrid. Therefore, investors should also consider the sensitivity of the change in a company’s credit rating to both the price and spread of the hybrid.
While investors may receive the invested capital back at maturity, some hybrids actually convert to ordinary equity. Therefore, in this circumstance many hybrids have a high correlation to the performance of the equity market (or the share price of the headline issuer company).
And fourthly, hybrids should not be viewed as a standalone investment, but part of a broader diversified investment strategy. In terms of portfolio construction, we believe hybrids do have a role to play. However, while hybrids are designed to provide additional and diversified sources of income to investors, the allocation to hybrids needs to reflect the underlying risk tolerance of the investor. Accordingly, given the potential risks associated with hybrids, they should not be viewed as a substitute for lower risk investments.
Overall, hybrid securities are just one of many ‘tools’ available to company management as a source of providing capital. While the attractive nature of hybrids in terms of income can make them compelling for investors seeking yield, they are not without risk. Therefore, understanding the nuances and structure of a hybrid security is a critical element in ensuring that when the time comes an investor can make the most appropriate and informed investment decision.
Piers Bolger is head of research and strategy, advice and private banks at BT Financial Group.
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