Listed Debt & Hybrid Investments
What are they?
Hybrids are a broad classification for a group of securities that have the characteristics of both an interest bearing security and equity i.e. both bonds and shares. They may incorporate a more debt-like bias or have more equity-like features, depending on the needs of the issuing company.
Hybrid securities pay a predetermined (fixed or floating interest) rate of return or dividend until a certain maturity date, at which point the holder has a number of options including being repaid in cash or converting the security into shares (sometimes at a discount) of the issuing company, which may pay fully franked returns.
The interest rate is determined by a margin over the market rate, usually the Bank Bill Swap Reference Rate (BBSW).
There is a decision to make when investing in a hybrid security based on returns, i.e. whether to invest in a security that pays interest, or one that pays a fully franked dividend. Consider whether you can utilise the franking credits or whether the cash timing benefits of unfranked distributions is a better option for you.
Retail investors can purchase hybrid issues through IPOs from the issuing company. Investors also have the option to purchase through the ASX on the secondary market.
There are different classes of hybrids and the conditions, timeframe, risks and interest rates of each hybrid differ:
- Convertible notes. Securities that pay a fixed coupon rate and can be converted into ordinary shares at a particular date or period of time in the future.
- Convertible preference shares. Securities that convert into a dollar amount of the ordinary shares of a company at a future date at a set dollar amount, or at a discount to the ordinary share price at that time.
- Reset preference shares. Securities that typically pay a fixed rate where the coupon is set for a defined term. At the end of the defined term, the securities are paid out and the investor is invited to re- invest from the current prospectus detailing the latest terms and conditions and a new fixed coupon rate. They are typically perpetual in nature i.e. no set maturity date.
- Step up preference shares. These securities normally pay a floating rate coupon and have a call date after a set period. If these securities are not called at the first call date then the coupon ‘steps-up’ to a higher rate to compensate investors for non-redemption. They are typically perpetual in nature i.e. no set maturity date.
- Subordinated debt. These securities are usually unfranked and are paid out in cash at maturity. They generally rank behind senior secured debt and senior unsecured debt, although they rank above hybrid securities and ordinary equity.
Advantages of ASX-listed hybrids
- Generally offers higher returns than more senior securities of the issuing company, reflecting their higher associated risk and their position in the company's capital structure.
- Offers a yield premium for their credit rating.
- Provides potential tax benefits through fully franked distributions.
- May provide the opportunity to participate in the company through the share conversion option.
- Ranks ahead of ordinary shareholders.
- Offers a wide range of issuers, maturities, structures and varying liquidity, ensuring that investors are able to construct a diversified portfolio.
- ASX listing provides liquidity, full company reporting and disclosures.
Risks of hybrid securities
- Subordinated ranking. Hybrid securities are generally unsecured, meaning that repayment is not secured by a mortgage or security over any asset. If a company fails, hybrid investors have to line up behind these creditors and bondholders for their money. Hybrid investors do rank ahead of ordinary shareholders.
- Market price volatility. Like company shares, the market price of listed hybrid securities may fall below the price the investor originally paid, especially if the company suspends or defers interest payments, or if its performance or prospects decline. Changes in the company’s share price and in other interest rates may also be reflected in the price of the hybrid listed security. This means you can incur capital losses.
- Deferral of interest payments. Some offers allow the company to suspend interest payments for a number of years. While the interest owing may be cumulative, this could leave investors temporarily out of pocket.
- Early termination. Some hybrid offers allow the company to terminate or ‘buy back’ the investment early but do not give the same right to investors.
- Perpetual/extremely long timeframes. Some hybrid structures can effectively become a ‘perpetual’ instrument which means the security does not have a fixed maturity date. And some hybrids have investment terms lasting several decades. As a result, investors may be required to bear the financial risks associated with an investment in long-term security. You may be able to sell the security on a secondary market such as the ASX, but only if there is demand.