There is a rapidly increasing number of Australians approaching retirement who don’t view declining interest rates with the same relish as much of the rest of the population.
Since the global financial crisis, retirees have flocked to term deposits because of the attractive rates, and the security and stability they offer. However, the decline in interest rates, leading to lower term-deposit rates, is presenting many retirees with this predicament: accept lower incomes and less favourable lifestyles or seek out alternative investments to boost returns.
Hybrid potential
While a decline in interest rates would traditionally represent the sweet spot for equity markets, Australian investors are looking for less risky options. There’s been a surge in demand for what might be called intermediate risk investments, such as subordinated bonds, often referred to as hybrid securities.
Hybrid securities seem to offer the best of both worlds: a regular income stream and promised future-capital repayment but with a materially higher return, generally ranging between two and five percentage points above bank bill rates. However, they also carry higher risks.
Similar to shareholders, investors in hybrids may be one of the last groups of investors to receive their capital back in the case of bankruptcy or default by the issuing company. Therefore, default risk is potentially much higher than for a term deposit or conventional bond.
Investors may also see their hybrid investment potentially convert to shares at a future date, which can produce a significant equity component to the security’s valuation prior to conversion. This convertibility may be appealing when share prices are rising, but can have a detrimental impact on the value of the security if the share market declines.
Lasting value?
As a consequence, an issued hybrid security is likely over time to trade with much greater price volatility than, say, a government bond, but with likely lower volatility than the issuing company’s shares. This can affect the value of hybrid securities should investors wish to sell their investments prior to the maturity date. The trading price of a hybrid security could be well below its initial issue price in certain environments, something that cannot occur with a term deposit.
Another risk is that while generally listed on the share market, hybrid securities often don’t benefit from the same liquidity as the underlying shares of a company. In certain extreme market environments, it may be difficult to sell hybrid securities in the open market, let alone at a price near the face value of the security.
There may be callable options embedded in the security indicating potentially an early redemption date. However, these are at the discretion of the issuer of a hybrid and they have no obligation to exercise that option and repay the investment before final maturity.
In many cases the final maturity dates are extremely distant, sometimes 20 – 60 years into the future, while some others have featured the issuer’s right to convert to a perpetual security with no set maturity date.
Limit your exposure
One way of addressing some of the potential risks is to have adequate diversification amongst hybrid issues. Alas, the concentrated nature of our hybrid market is likely insufficient to deliver true diversification. This suggests investors looking for enhanced yield returns need to also consider credit investments outside of the hybrid space, including potentially international credit markets, as a way of reducing this concentration risk.
Hybrid securities can be an attractive option for many investors, but they shouldn’t be viewed as defensive assets similar to term deposits or government bonds. They are considered hybrid investments for good reason, potentially containing varying degrees of default or credit, market, convertibility and liquidity risk.
Investors should view hybrids as higher risk investments and take time to understand their characteristics and ensure they are being adequately compensated with sufficient additional returns for the risks taken. And it may be preferable to limit the exposure to hybrids in an investment portfolio.
Michael Karagianis is a senior investment strategist at MLC Investment Management.
