Hybrid securities are now looking better – but are they good enough?

They are not quite a bond, not quite a stock, but hybrid securities are enjoying a resurgence with investors drawn to their strengthening income returns.

Now that official rates have returned to relatively normal levels, it is a useful time to rethink hybrid securities and consider an exposure. Photo by: NCA Newswire /Gaye Gerard

They are not quite a bond, not quite a stock and critics say they sit in a no man’s land offering little value to investors, but hybrid securities are enjoying a resurgence with investors drawn to their strengthening income returns.

Now that official rates have returned to relatively normal levels, it is a useful time to rethink hybrid securities and consider an exposure.

Income payments from hybrid securities are set by using the bank bill rate, which is normally the RBA cash rate and adding a margin of 3 to 5 per cent on top depending on the specific hybrid. As the RBA cash rate increases, so does the income return from the hybrid security.

Most hybrids are now yielding between 6 to 7 per cent income which is paid quarterly and bank hybrids such as National Australia Bank Capital Notes 3 and Bank of Queensland Capital Notes 3 lead the way with grossed up distributions above 7.5 per cent.

While buying NAB and BOQ stocks would still provide a higher dividend than investing in their highest yielding hybrid securities, one of the advantages of hybrids is that they sit higher on the capital structure than ordinary shares, providing a slightly higher level of investor protection in the event of a corporate collapse. However, hybrids still rank towards the bottom of the capital structure and sit lower than unsecured debt such as bonds and notes.

One of the more infamous failings in recent years has been the Virgin corporate bond that raised $325m from investors in November 2019 and collapsed in 2020 without even making a single distribution to investors. This investment sat higher on the capital structure than hybrids but still resulted in a 100 per cent loss to investors.

In the current market some hybrids are yielding around 10 per cent such as Latitude Capital Notes and Judo Capital Notes however previous bond and hybrid failings from the likes of ABC Learning, Babcock and Brown, Timbercorp and Great Southern should serve as a reminder that hybrid investments are a high risk game.

The financial services regulator ASIC has been vocal regarding the risks of hybrids in the past warning investors “don’t be dazzled, be wary of the risks” and saying “hybrid securities are complex products. Even experienced investors will struggle to understand the risks involved in trading them. If you don’t fully understand how they work you should not invest.”

In the 100 to 200 page prospectus for each hybrid issuance, investors will need to comb through the fine print to find the terms and conditions around key terms such as payment of distributions, which are usually discretionary and non-cumulative and other risks such as “loss absorption events” which are triggered if the company goes into financial distress, at which time the hybrid is converted into shares but at an amount significantly less than the hybrid value.

The total market cap for hybrids is $45bn which in comparison to, say, the ETF market is relatively small. Although there are more than 200 ETFs on the Australian sharemarket, the top 5 ETFs (VAS, VGS, IVV, MGOC and STW) are worth as much as the total hybrid securities market.

That said, hybrids still hold appeal for investors who are happy with the trade-off that hybrids offer. Some hybrids operate in perpetuity however the majority have a maturity date at which point the hybrid is either redeemed for cash or converted into shares. This is attractive for investors who wish to invest for a certain period of time and want to know their capital value will be returned or converted into shares in the future, assuming the company has not gone into liquidation. Generating an income return that is higher than the RBA cash rate is also attractive for hybrid holders especially in current times where cash rates are elevated.

Although hybrids are primarily issued by banks, there are a handful of non-bank hybrids such as healthcare provider Ramsay and property manager Centuria which are paying 9.38 per cent and 8.47 per cent distributions respectively.

Betashares offers a hybrid security ETF which has experienced a relatively low 3.71 per annum return over the last five years with subdued interest rates. But the forward looking projected income return known as the “running yield” is much better at 6.62 per cent, reflective of the high current interest rate environment.

For investors who are looking for something with both bond and stock attributes and can accept the risk to capital and appreciate that income payments are not guaranteed, hybrid securities are looking markedly more attractive today compared with two years ago. But for naysayers who prefer buying bank shares rather than bank hybrids, the lack of capital growth and the questionable risk return matrix continues to make hybrids a no go zone.

James Gerrard is principal and director of Sydney planning firm financialadvisor.com.au