Introduction to hybrid securities

With interest rates at record lows, many investors are looking for ways to boost their income without increasing their portfolio allocation to risky shares.

Hybrid securities are one popular option, combining some of features of both debt instruments (bonds) and equity instruments (shares).

Issued mainly by banks and other large corporates, billions of dollars in hybrids now trade on the Australian Securities Exchange (ASX).

Hybrids are complex, and their features vary from one hybrid to another but, because of their higher risk, they generally pay higher rates of interest than savings accounts, term deposits or vanilla corporate bonds.

What is a hybrid?

Hybrids are securities that banks and companies issue to borrow money from investors.

Like a bond, hybrids generally pay a fixed or floating rate of return until a predetermined date, when the hybrid will mature and the investor should be paid back.

However, unlike a bond there is no actual guarantee about the timing or the size of these interest payments or that the investor will receive their money back.

Each hybrid is unique, depending upon the terms specified in the Product Disclosure Statement (PDS), so it is important to study these closely and make sure you understand them.

There are two main types of hybrids: bank and corporate.

Bank hybrids

Banks issue a special type of hybrid that is 'loss absorbing'. If the bank gets into financial trouble, it can convert the hybrids into bank shares. This is likely to be the worst time to buy the bank’s shares, so they might be worth less than your initial hybrid investment, or even worth nothing. In this instance, you would lose money.

This feature protects people who have deposited money with the bank at the expense of investors who own the bank’s hybrids.

While this may make hybrids sound very risky, bank hybrids remain popular because investors believe there is only a small chance of a major Australian bank getting into financial trouble. Banks are closely regulated by the Australian Prudential Regulation Authority (APRA) to ensure that they are financially strong.

Corporate hybrids

Large corporations issue hybrids promising regular interest payments but these corporations can typically defer interest payments for years and may not repay your capital for decades.

Corporate hybrids are also known as 'subordinated notes'. This means corporate hybrid investors are subordinate to the company’s other debt holders, so they will be paid back last in the event of insolvency. Interest payments may also be delayed until other debts are paid.

How do I invest in hybrid securities?

Hybrid securities can be listed on a securities exchange, or unlisted.

Listed Hybrids

You can buy and sell hybrids listed on the Australian Securities Exchange (ASX) through any stockbroker.

Unlisted Hybrids

You can buy unlisted hybrids directly from the issuer. You can't trade them on the ASX, which means they are harder to sell and harder to value.

Pros of investing in hybrids

  • the potential to receive an income stream for an agreed period.

  • generally lower price volatility than shares.

  • usually higher interest rates than are paid on bonds, reflecting the higher risk.

  • diversification, and the potential to benefit from changes in interest rates or equity prices.

Cons of investing in hybrids

  • there are less buyers and sellers in the market for hybrids than for company shares. If you need to sell fast, you may have to accept a lower price.

  • There is little diversification benefit if you already own bank shares.

  • hybrids are more complex than shares or bonds.

  • some hybrids allow the issuer to withhold interest payments if they get into financial difficulty.

  • you can be the last creditor to get your money back if the company becomes insolvent.

  • Your hybrids may be converted into shares when the value of the bank or company falls. The shares you receive may be worth less than your initial investment.

  • some hybrids are written off completely if the issuer gets into financial difficulty.

Alternatives to Hybrid Securities

A Residential Mortgage-Backed Securities (RMBS) fund is another option that investors looking for stable monthly income might consider.

RMBS funds have portfolios of bonds that are each comprised of thousands of home loans.

These RMBS bonds receive regular income from the mortgage repayments of Australian homeowners.

The High Livez fund is one such fund, which gives retail investors access to a type of security that is usually the exclusive preserve of big institutions. Invest as little as $10,000 with zero entry and exit fees.

Distributions

  • High Livez - Distributions are paid monthly, generally within 10 business days after the end of each month.

  • Hybrids - Distributions are usually paid quarterly, according to the terms set out in the Product Disclosure Statement (PDS).

Risk

It is hard to compare the risk of such different investments, especially as hybrids vary so much depending upon which entity issued them and the unique features of the hybrid. Be sure to read the Product Disclosure Statement (PDS) for each investment and obtain independent advice.

Find out more about High Livez here.