We’re not talking about reducing your emissions, but rather trying to boost your returns. With the All Ordinaries index having fallen 48 per cent (and that includes a 15 per cent rally since early March), some investors are considering the alternatives for their investment dollars. How do hybrid securities measure up?
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.
