Are Hybrids Defensive Assets?

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Do you want to go into the match with a hybrid defense (sort of defensive and sort of attacking)- which may lead to a good result in an easy match, or a solid, boring defense – which may protect you more when the going gets tough?

Hybrids are a form of investment where you loan your money to a company which is usually listed on the stock exchange, in exchange for an interest rate.

So far that is sounding like a genuine fixed interest investment.

But according to the MoneySmart website, you take all the risk. It may be an acceptably small risk to you – but you need to understand the potential risks at least.

‘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.

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.

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 from Hybrids

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.’ read more here:

Australian Corporate Bond Company (ACBC) chief executive Richard Murphy was quoted in Investor Daily (14th March 2016) as saying:

‘While hybrids have features of a fixed-income product, they are not defensive in shielding portfolios against market downturns. When equity prices fall, hybrids tend to behave more like equities.’

A recent survey by the ACBC revealed that 47 per cent of respondents either classified hybrids as fixed income or did not know how to classify them.

It may not be surprising that a company specialising in Corporate bonds (which are defensive assets) would have the view that hybrids should not be classified as defensive assets, but this is backed up by the fact that Morningstar head of Australian credit research, John Likos, shares that view.

‘The increasingly issuer-friendly terms contained in hybrids suggest they shouldn’t be included in the defensive fixed-income part of a portfolio,’ he said.

And yet, anecdotally, many SMSFs and their administrators are counting hybrids as part of their defensive assets.

What seems to have changed with Hybrids, in recent times is the terms. How many SMSF investors would be aware of these terms?

There is a very real risk that although they read the terms for their first Hybrid investment 5 years ago, they will assume that the terms for a new hybrid investment they are considering today would be similar – and this may not be the case at all.

Whether hybrids are suitable depends on each investor’s circumstances, objectives and attitude to risk.

Disclaimer: Past returns are no guarantee of future returns. None of the content in this article should be construed as advice. Speak to your professional adviser about your circumstances and objectives before taking any action.

 

 

 

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