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In his latest feature for Income Asset Management, bond market expert Matthew Macreadie – Director of Credit Strategy at IAM – highlights the risks for investors to be aware of with Hybrid investment instruments.
In today’s low interest rate environment where term deposit rates have remained stuck near zero, hybrid investment options have become more popular.
So-named because they typically include characteristics of both debt and equity investments, investors have been attracted to the regular distribution payments, along with the higher-return profile of hybrids compared to bonds.
However, despite their many positive features, hybrids do carry higher risks compared to Australian corporate bonds – which many investors don’t realise.
While allocating a small portion to hybrids can be effective, an approach highly focused on this asset class could pose problems. Here’s a few points to note, for starters:
- Hybrids historically have had a higher correlation to equity markets
- Hybrid debt issues are less frequent than Australian corporate bond issues
- Hybrids have significant call-risk relative to Australian corporate bonds.
That last point, call risk, is the risk that a hybrid issuer may forcibly redeem the hybrid instrument prior to maturity – which may not suit the time frame of the investor who acquired it.
IAM’s suggested approach would be to adopt a diversified portfolio, with adequate exposure to Australian corporate bonds alongside hybrids.
Particularly in today’s environment, IAM place an emphasis on downside protection during market turbulence – like we have seen in the past few months.
There’s no doubt hybrids have a place, though the current returns from hybrids (especially financial hybrids) do look on the expensive side on a risk-reward basis.
For example, the investment yield to expected maturity/first call on Australian bank hybrids are currently trading at around 3-4% (unfranked).
IAM believes five-year bank hybrids offer better value at around the 5-6% mark (unfranked). Here are three reasons why:
1. Hybrids historically have had a higher correlation to equity markets
Over the GFC period, bank hybrids experienced close to a 20% drawdown (or price decline).
That fall was primarily attributable to capital losses from the discount margins on these securities, which increased from around 1% pre-GFC to around 5.5% post-GFC.
Using this as a proxy for the current environment, if discount margins were to increase from the current 2.75% to around 5% over the next year, the capital loss would be ~6.5% offset by 2.75% income – thus, a drawdown of ~3.75%.
The recent experience for bank hybrids has been more muted. Bank hybrids are down by around 2-3% (in price terms) over calendar 2022 YTD compared to the ASX200, which has seen more volatility.
The GFC period was highlighted by:
A fear of economic slowdown/banking crisis;
Protected equity market weakness; and
- Large drawdowns (bank share prices falling by 20% plus).
The chart below gives a longer-term perspective of credit (or discount margins) for four types of credit investments: BBB rated bonds, US High Yield, CoCo (non-AUD, AT1/Hybrids), and Australian AT1/Hybrids). The last data point is 26 January 2022.
While BBB rated bonds do have some spread volatility (albeit, less so than AT1/hybrids), the bulk of the Australian corporate bond market sits in the A rating and above.
A-rated bonds have historically had very low spread volatility, and their risk-reward characteristics are better given the potential drawdown risks that currently exist in the market.
2. Hybrid debt issues are less frequent than Australian corporate bond issues
The Australian corporate bond market has grown by more than 40% since 2010.
Currently, there are over $1 trillion of Australian corporate bonds outstanding across governments (state and federal), asset-backed securities, financial and non-financial corporates, inflation issuers, and hybrids.
However, the hybrid market is only a tiny segment of the Australian corporate bond market at ~$47 billion, or 5% of Australian corporate bonds outstanding.
Most of the debt issues are classified as ‘convertible preference shares and capital notes’, and are issued from several financial institutions (mostly the major banks and Macquarie).
This also creates significant concentration issues with the Australian banking sector.
In years past, hybrids were also used by large corporates (for example, Crown, Nufarm, and Qube) to obtain a level of equity credit in order to improve their credit metrics.
Rating agencies have since made this process more onerous on issuers, which, alongside the improved liquidity for cheap funding from the corporate bond market, has seen a tailing off in corporate hybrid supply.
The issue hence becomes one in which investors can only get exposure to hybrids via the banks.
As debt issues are less frequent in nature, replacement of capital then becomes very difficult, which poses reinvestment risk.
Generally, the hybrid market is also not a heavily secondary traded market. On average, the number of trades per day is around 1,500, with a value of ~$700m.
As an example of how that higher risk plays out in the market, the bid-offer spreads (i.e., the difference between the market price at which the hybrids can be bought and sold) for CBA hybrid securities can be larger than the spread on its actual shares.
3. Hybrids have significant call risk relative to Australian corporate bonds
The perpetual nature of many hybrids (especially the financial hybrids) means there is essentially no guarantee of getting your money back, and thus no reliable yield to maturity (%).
There are ‘reset periods’ with ‘reset margins’ but there is no end date for getting paid back.
For this reason, investors are generally better placed to assess the running yield (%) for that period, and then make a judgement as to whether they are comfortable or not.
Call risk also tends to rise in a higher interest rate environment, as the issuer can hold onto old, low-rate hybrids rather than issuing new hybrids which have a higher rate of interest.
Generally, corporate bonds have a hard bullet maturity. All-else-equal, investors can be comfortable with the yield to maturity (%) on offer.
The other issue is that if a hybrid isn’t redeemed, it’s probably going to be a result of wider market turbulence.
So, if an investor wanted to exit, they’d be selling into the eye of the storm and potentially running into liquidity issues and realising a sizeable capital loss to do so.
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Pricing as at 14 February 2022.
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