How hybrid securities can be used to reduce investment risk

Stephen Hart explains how to use hybrids in place of equities to reduce risk, but without compromising returns.

Many fixed income investors segment hybrids away from fixed income. Instead, they put them together with equities, because both hybrids and equities typically trade on equity exchanges. But should hybrids and equities be segmented together or should they be used independently?

As I will demonstrate below, hybrid securities can offer a useful alternative to equities as a means of diversifying returns in a balanced portfolio. The risk, return and correlation characteristics of the various asset classes suggest hybrids can be used to reduce portfolio risk without having a significant impact on returns.

Let’s have a look at the evidence in support of this view.

Asset class characteristics

To begin with, let’s look at the daily data from January 2000 to March 2010 for the following asset classes:

• Elstree Hybrids Market total Accumulation Index (Hybrid M);
• Elstree Hybrids Financial Market total Accumulation Index (Hybrid F);
• Equities, using the ASX 200 accumulation index (ASX 200 Accumulation Index);
• UBS Australia Bank Bill Index Bank Bills, using the (Bank Bills Index);
• UBS Australia Government 0+ yrs Nominal Bond Index (Nominal Bonds); and
• UBS Australia Government 0+ yrs Indexed Linked Bond Index (Inflation-Linked Bonds).

Figure 1 shows the values since January 2000 for these indices. It also shows that equities are, by far, the most volatile asset class — with bank bills exhibiting the least volatility.

Another way to look at the performance variations is to examine the risk/return relationship across the asset classes (see Figure 2).

While bank bills exhibit the best risk/return ratio, other asset classes such as fixed income and equities deliver higher returns.

Fixed income has much better risk/return characteristics than equities.

The hybrid data is a little short in duration (representing the longest period available for hybrid indices) but when adjustments are made for the time specificity of the data set by including data for equities from June 1992, risk stays at about the same level on average (although return from equities is a little higher).

When we plot these risk/return characteristics, the relationship between risk and return becomes evident (see Figure 3).

The conclusion here is that an investor seeking higher returns from equities must take on significantly more risk. Specifically, they must double the risk to deliver only a marginally higher return.

Asset class correlation

While this data indicates the broad volatility and return characteristics of the selected data, it does not indicate how the various asset class total returns move together.

In particular, the information we need to know for any given change in one asset class is the expected average return in another asset class.

Correlation analysis is of some assistance here, and Figure 4 shows the correlation of each of the asset classes with one another.

Figure 4 also indicates that nominal government bonds and inflation-linked bonds (ILBs) are reasonably highly correlated.

This means when one asset class moves down in price you can generally expect the other to move down in price too.

However, the correlation between both these asset classes and bank bills is quite low, so we can create a better portfolio by adding bank bills to a portfolio of nominal bonds and ILBs.

The low correlation between fixed income and hybrids is interesting because it suggests that a change in the total return for fixed income is not normally associated with a major change in return from hybrids.

Often equities are used to create a more diversified portfolio as the correlation between equities and bonds is low.

However, you could argue that hybrids offer equal or even better diversification benefits, as Figure 5 indicates. Here, a theoretical portfolio is calculated daily and the overall risk/return characteristics over the period between 1 January 2000 and 29 March 2010 can be determined.

Portfolio 1 in Figure 5 is a simple combination of nominal bonds and ILBs, giving a risk/return ratio of 1.37. Importantly, as we add hybrids, the risk/return ratios improve to 1.83 in Portfolio 2, which has 33.3 per cent hybrids, 33.3 per cent nominal bonds, and 33.3 per cent ILBs.

Also, the risk/return ratio goes to 2.36 in Portfolio 3 and 2.29 in Portfolio 4. If we were to add equities in place of hybrids in an effort to reduce risk and boost return, the results are not as compelling as shown in Portfolio 5.

If we use hybrids in substitution for equities what about the age-old belief that equities offer a hedge against inflation? Will hybrids deliver a similar performance?

The available evidence does not support the notion that a relationship exists between equities and inflation. If there is any relationship at all, the evidence suggests equities and inflation are negatively correlated.

This should not be surprising given the poor performance of equity markets during the high-inflation seventies and the better performance of equities since, during which inflation has moved lower.

In this article we have examined the asset class characteristics, risk and return, along with correlation of total return.

We have found that while fixed income provides a better ratio of risk and return against equities, portfolios typically use equities as a means of diversifying risk and boosting return.

We can see that hybrid securities provide an alternative for investors moderating portfolio risk due to the low correlation between fixed income and hybrids.

By adding cash and hybrids to a portfolio of fixed income assets it is possible to significantly reduce risk (by almost half) while not significantly affecting return.

In other words, it can be argued that hybrids should be seen as an integral part of a balanced investment portfolio together with cash or term deposits, rather than being treated as an integral part of an equity portfolio.

Hybrids offer a better diversification alternative to equities for investors who are weary of bearing equity risk.

Stephen Hart is director of planner services at FIIG Securities.