Hybrids are securities that fall in between equity and debt and have some of the characteristics of both. They include redeemable preference shares, subordinated debt and convertible securities.

Hybrids can have a whole range of different attributes and no two issues are the same.  Some security structures can be quite complex and it is essential to understand the investment before committing funds. In addition, an investor needs to understand the underlying business behind the security.

There are many types of hybrids and they have been evolving over time. A recent iteration is perpetual step-up preference shares (SPS). Introduced in 2004 in response to changes to accounting standards, SPS are perpetual in nature, with the decision to redeem or rollover resting with the issuer, not the investor. This feature makes them similar to equity.

SPS also have debt like features. They typically pay a floating interest rate at a margin over a benchmark rate. The payments may be franked. There is no maturity date as such but a key date is the step-up date. At the step-up date they may be redeemed at face value, re-marketed with new terms or reset at a higher (step-up) margin. The decision rests with the issuer, not the investor. They are not convertible into ordinary shares.

One example of a SPS is the Australand Subordinated Step-up Exchangeable Trust Securities (ASSETS) issued in 2005. The key features of ASSETS are:

•    pay floating rate, quarterly, non-cumulative distributions
•    the distribution rate (until the next step-up date (1 October 2011)) is the 3-month bank bill swap rate plus 4.80 per cent margin
•    perpetual in nature and recorded as equity on the balance sheet.
•    the issuer may initiate a re-marketing process at the step-up date to set a new margin
•    if a new margin is not set, the margin will be increased by the step-up margin of 2.50 per cent.

The initial step-up date was October 2008 when credit conditions were very tight and many corporations were finding difficulty refinancing maturing debt. Australand was able to retain funding through ASSETS by invoking the step-up margin. This meant a higher funding cost, but in the tight credit environment, that was not such a bad outcome. Since then the three-month bank bill swap rate has fallen significantly, reducing Australand’s funding costs.

ASSETS are trading on a current yield of about 18 per cent. This is an attractive return providing the downside risks are not too high. Payments are not guaranteed, but no distributions can be made to stapled security holders until the ASSETS payments have been met. They rank behind senior debt but ahead of stapled securities in terms of security. The question is, is the yield sufficient return given the risks the business faces?

A number of other SPS’s are also trading on yields of around 18 per cent, including Goodman Plus SPS, Multiplex SITES and PaperlinX SPS. Are these yields attractive, or are the risks too high? Is their a likelihood of capital gains if yields fall? What would the contrarians think?

Chris Batchelor is senior technical writer for Kaplan Professional

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How about a hybrid?
written by cbatchelor, May 12, 2009

As you point out it is essential to consider the risks of capital loss. The biggest risk for a hybrid is the threat of bankruptcy. If a company goes bankrupt, hybrids will rank well down the list of creditors to be repaid. Investors are likely to loss most or all of their capital. Which begs the question, how might an investor evaluate the risk of bankruptcy.

In regards to investors who have lost capital, whilst it is always sad, there is nothing that can be done about it except to learn from the mistakes. All investment decisions need to be made by comparing expectations of the future with where we are today. Yesterday is irrelevant except for history lessons.

A good way to reduce the likelihood of significant loss is to invest with a margin of safety. For example if your required return from a particular investment is 12%, but you are able to invest at a yield of 18%, then you have a substantial margin of safety.

As with all investments, it is a mattering of weighing the potential returns on offer against the risks. Some hybrids have rallied over the last few weeks, narrowing the margin of safety. One went broke.

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written by Joe Christie, May 11, 2009

18%+ appears to be a good return (granted nothing is risk free). You mention the potential for capital gain and I agree a gain is quite likely.

The only thing to consider is that many investors have lost significant amounts of capital over the past year or so and there is also a chance that Hybrid investors could risk some capital loss of economic conditions decline further.

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