The Role of Hybrids
Editor
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Hybrids are a form of interest rate security that share some features of bonds and some features of equities.
They offer the opportunity for the investor to receive regular dividend (or coupon) payments (that may be higher than what you might receive from bonds) and the opportunity to get a full return of your original capital after a specified time period (just like bonds) – assuming the issuer remains solvent of course.
The dividend payments are often quoted at a fixed margin above the 90-day bank bill rate, and as such will tend to move up and down in line with this.
In addition, some hybrids may be converted (according to a pre-determined formula/calculation) into ordinary shares at the end of this specified time period.
They rank above ordinary shares in the capital structure of a company, and as such have priority of repayment over shareholders in the event of the winding up of the company.
In addition, due to this position in the capital structure, a company usually cannot pay a dividend to its shareholders if it does not pay one to the holders of their hybrids.
Exactly how far above ordinary shares a particular hybrid sits in this capital structure, and thus how safe and secure they are, depends on the particulars of each hybrid offering.
Many sit only just above ordinary shares, and thus are only really slightly less risky than holding ordinary shares.
In general though, hybrids are considered unsecured and “subordinated” investments, ie. they tend to rank behind other creditors of the issuer.
To understand the role of hybrids in a portfolio the first thing to do is to consider how they compare to holding ordinary shares, particularly when looking at hybrids that sit quite low in the capital structure.
In our view, in most cases fully-franked ordinary shares are a better longer term option than hybrids for investors where having a growing long-term passive income stream is the greater priority, as opposed to redeeming their original capital amount after a certain specified time period (which is not possible to be certain of with ordinary shares without paying for some sort of “insurance” through put options or warrants).
The reason for this is that even if a hybrid offers a relatively high initial yield, eg. 6-9% p.a., your regular dividend payments will tend to move up and down with the 90-day bank bill rate, and as such any growth in your annual dividend payments is strongly influenced by movements in this rate.
This rate can go up and down in cycles of varying time periods (and in recent times quite short time periods) and as such can restrict your ability to achieve long-term sustained income growth.
If you were to buy ordinary shares on the other hand, that may be purchased at a relatively lower initial yield of say 3-6% p.a., holding the ordinary shares gives you full exposure to any upside in annual income through dividend growth, which may move higher, faster and more predictably than the 90-day bank bill rate, and over a much longer time period (ie. longer than the term of the hybrid) that won’t necessarily be directly correlated to cyclical movements in the 90-day bank bill rate.
If this occurs your yield on the ordinary shares purchase price in say 5 years time may be significantly higher than the future yield of the hybrids – assuming of course that you selected the right shares for this purpose in the first place.
That being said, this is a two-edged sword in that dividends from ordinary shares can decrease or even be cut.
Hybrid dividends can also be cut, but any decreases are limited to the margin above the 90-day bank bill rate (assuming the bank bill rate goes as low as zero).
This all being said, if you are to invest in hybrids, it makes sense to do so when interest rates are at a low point in the interest rate cycle (and anticipated to move upwards within the next 12 months) and with a good margin above the 90-day bank bill rate.
Right now in fact we appear to be at a historically low point in the interest rate cycle.
And to invest in hybrids which are likely to be redeemed or converted in 5-7 years or so, rather than become “perpetual” with indefinite terms.
If so, after 5-7 years you can if you want then rollover to the next best hybrid offering rather than be locked into a hybrid with a yield that is no longer competitive in the marketplace.
Further, choosing hybrid offerings from large capitalisation stocks like the big 4 banks are generally a safer option in terms of credit risk, but this depends on the particulars of the hybrid offering and is beyond the scope of this blog post.
We also suggest that hybrids should be allocated to the part of your portfolio that would have ordinarily been allocated to cash/term deposits/bonds, and as such in general you should not be too overweight in hybrids and replace too much of your equity (or property) exposure with hybrids as it may affect your long-term income growth potential.
And further to not replace your entire exposure to cash/term deposits/bonds with hybrids as in distressed market or company specific situations hybrids may behave more like equities than bonds.
Diversifying and having exposure to several hybrids at the same time also makes sense.
We also suggest avoiding buying hybrids with margin loans or any borrowed funds as hybrids have generally reduced capital growth potential (ie. only if you purchase them below their issue/listing price or sell them before the end of their term at a premium) and run the risk of the 90-day bank bill rate turning downwards suddenly and creating a negative gearing situation.
We have included more detailed educational resources on hybrids as a part of our How to Invest in Bonds section available to all members.
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