How ‘ridiculous’ are hybrids for retail investors?

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For many years, much has been written about the apparent complexity of hybrids and how they should not be sold to retail investors. The outgoing ASIC chairman, Greg Medcraft, last week went as far as saying they were a ‘ridiculous’ product for retail investors.

However, in the last five years or so of hybrid bashing, I have never seen anyone suggest that retail investors should be banned from investing in equities issued by the same companies. Equities are more complex with many more moving parts for the average punter to comprehend. Compared with hybrids, equities are significantly more volatile and are far more likely to experience a rapid fall in value, dilutionary equity raisings, reductions or complete cuts of income (i.e. dividends) and even a complete loss of value. While the downside of equities can be significant, the trade-off is there is no limit to the upside.

As an analyst, I work in probabilities and facts. Yes, the hybrid (and equity) prospectuses can be complex to read, however, when it is boiled down there are five simple questions that cover the majority of scenarios.

Five questions to ask

1. Is the hybrid issued by a regulated bank or insurance company?

Banks and insurers are preferable issuers as there is the added protection of a regulator monitoring the company and a defined set of rules, which govern the disaster scenarios.

Moreover, banks and insurance companies have reputations to uphold and as regular issuers of debt, they do not want to let investors down as it will cost them in higher margins next time. Further, they are typically rated by one or more agencies. With corporate hybrids, on the other hand, I always assume the company will do what is best for the company, not the investor.

2. Will I get paid my quarterly distribution?

There is approximately a 99% chance of payment. The main concern is how hybrid distributions can be cut if ‘this, that or the other’ happens. However, to my knowledge, no Australian major or regional bank or insurance company has missed or even deferred a coupon on any hybrid in the past 20-odd years. For highly-rated banks and insurance companies, I assign a probability of a missed coupon at less than 1% on a five-year horizon.

Another way to assess the risk of income loss is to ask, “do I think the company will cut their share dividends to zero at any point in the next five years?” Practically all hybrids have a ‘dividend stopper’ which says if the company misses paying a hybrid coupon then they are not permitted to pay a dividend to shareholders. For large banks, insurers and corporates, the prospect of not paying a dividend would be a last resort and a significant deterrent. If a company is paying dividend, it must pay all hybrid distributions – a very simple test.

3. When will I get my money back and how much will I get back?

There is around a 95% probability of full capital return at first call date and 98-99% probability of full capital return by mandatory conversion date.

Once again, much has been written about call risk and the prospect of being converted into equity, potentially at a loss of capital. Talking facts and probabilities, to my knowledge all Australian major and regional banks and insurance companies have called/redeemed when expected for at least the past 10 years. In almost all cases, this is the first possible call date.

Further, no Australian bank or insurer has been forced or chosen to convert hybrids to equity under the new Basel III regime. Regulations and capital buffer requirements are far more stringent since the GFC, a crucial fact that is often missed in the discussion about the risk of hybrids.

Last week APRA released their ‘Unquestionably Strong’ capital requirements for Aussie banks. Once fully implemented in 2020, some local banks will have almost double the capital buffer compared to pre-GFC levels (and many of the world’s leading banks have close to three times the capital from pre-GFC levels). This is capital that ranks below the hybrid level and is used to absorb losses before impacting hybrid investors.

The risk of default by all hybrid securities has been massively reduced, due to the enormous build up in common equity capital buffers, and the huge importance placed on this capital. Monitoring of early warning signs by the regulators such as APRA (arguably the world’s best regulator) also lower the risk of default. Bank and insurance boards’ desires to have an adequate buffer over the minimum requirements have reduced the risk of default for all hybrid securities.

Capital ratios for Australian banks

For the new-style/Basel III compliant mandatory converting hybrids issued by the major banks these days, I assign the following approximate probabilities:

  • 95% chance of call at first opportunity.
  • 3-4% chance of conversion into equity two years after first call.
  • 1-2% chance of an unexpected outcome such as continuation or conversion to equity later than the scheduled conversion date, conversion into equity at a loss or default.

Would an equity investor refrain from buying a particular share if there was a 1-2% chance of a delay or risk in receiving back the initial investment amount?

Like most debt securities, hybrids issue at $100 and redeem at $100, and the value can vary in-between (in the vast majority of cases no higher than $110 and no lower than $90). Ideally, we look to buy hybrids at a discount when the opportunity arises to counteract the ‘no upside like equity’ argument.

Granted there are a few apparent exceptions that have gone past their call dates such as NABHA, MBLHB and SBKHB. However, these were not sold with the expectation they would be called at the first opportunity. They were different due to a unique set of regulatory and tax rules that existed for a short period in the late 1990s when they were issued. It is these ‘legacy’ issues (which in my estimation account for just ~1% of all hybrid issues in the past 20 years) where investors may need some help from industry experts. The ANZPCs could also be considered an exception. While we expect them to be called in September 2017, they fall into the 3-4% that may go to the conversion date.

It is the 1% of ‘different’ hybrids that tar the other 99% with the ‘complex’ brush. However, it is the misunderstood securities that present the best opportunities if time is taken to understand them.

4. Can I live with potential volatility?

The main risk of hybrids is they can be volatile in times of stress. In the GFC, some major bank hybrids fell circa 30%. However, bank share prices fell double that. I expect the fear of conversion into equity under Basel III from a predominately retail investor base would likely see some material price falls in times of extreme stress, but therein lies a potential opportunity.

As a rule of thumb, I assume that in a stressed environment such as the GFC, hybrids will fall around half of the decline of the underlying equity. Unfortunately, the Australian dollar hybrid market is now almost exclusively floating rate notes, which do not benefit from falling yields in a crisis scenario.

For investors who cannot afford to hold until expected maturity or call date or until the price recovers, this may be an issue. Further, if the volatility of hybrids is unacceptable, then the volatility (and significantly higher risk to income) of equities should also be unacceptable.

5. Am I being paid for the risk?

Typically, a hybrid pays two to three times a term deposit return for arguably a minor increase in default or missed income risk (in probability terms).

The main risk is volatility in times of stress, not credit risk. Hybrids provide better risk-adjusted returns versus sub-investment grade or unrated corporate bonds with similar yields or margins.

All investment decisions come down to ‘am I being paid enough for the risk I am taking?’. Comparing hybrids to term deposits needs to recognise the extra return for the risk.

Assessing the risks

The key to assessing the risk is to consider:

  • Probability of default, and
  • Loss if a default occurs

The massive increase in capital buffers and regulatory oversight in the past decade has de-risked bank and insurance hybrids. Yes, there are provisions to cancel coupons, defer expected maturity/call dates and convert into equity (potentially at a loss) but these risks are minimal, especially for best of breed, highly rated APRA regulated banks and insurance companies.

The much-feared ‘conversion into equity or point of non-viability (PONV)’ clause in the new style hybrids is unlikely to be triggered. I would argue that whether under the old regime that existed at the time of the GFC or the new Basel III PONV rules, if a bank has capital so low that the regulator has to step in, the value of the hybrid Tier 1 capital (and the Tier 2 subordinated debt capital) at that time would be less than 10% and most likely close to zero.

For major banks, I assume less than 1% chance of default and a zero recovery in that unlikely event.

Compare that to sub-investment grade or unrated bond issues from small companies. For example, a single-B senior unsecured bond has a historical probability of default over a five-year period of around 18.5%. Loss given default is dependent on the facts but would typically be 80% to 100% loss for anything with a material amount of senior ranking bank debt, especially for a ‘cashflow lend’ to a company with few hard assets.

Investors need to be aware of what could happen, but the investment decision should be based on what is expected to happen i.e. probabilities.

Not a good time to buy hybrids

While we are comfortable with the risk/reward dynamics of the new-style bank and insurance hybrids, the current returns from bank and insurance hybrids on an outright basis are on the expensive side. The yield to expected maturity/first call are around 6-7% or trading margins in the mid-300 basis points (3%). Our general rule of thumb is that five-year hybrids are good value when trading margins are closer to +500 basis points (5%) and fair value at around +400 basis points.

Corporate hybrids and hybrids from non-Australian banks and insurers are more complex and do require additional analysis to understand the market and regulatory drivers.

 

Justin McCarthy is Head of Research at Mint Partners Australia. The views expressed herein are the personal views of the author and in no way reflect the views of the BGC Group. Individuals should make investment decisions based on a comprehensive understanding of their own financial position and in consultation with their own financial advisors, and no responsibility is accepted for the opinions in this article.

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8 Responses to How ‘ridiculous’ are hybrids for retail investors?

  1. David August 3, 2017 at 12:34 PM #

    Neat counterbalance to recent opinion from ASIC, but the use of back of the envelope calculations on default rates makes me a little nervous.

  2. Fergus Hardingham August 3, 2017 at 1:45 PM #

    Maybe hybrids are not appropriate for retail investors where the retail investor is investing in them thinking that they are a direct replacement for bonds / fixed interest and don’t understand the purpose of the issuance of hybrids and their inherent risks. For well advised hybrids as part of the portfolio we see no issue. But would refer the exposure to such investments be done via professionally managed investments vs direct holdings.

  3. Richard Murphy August 3, 2017 at 1:57 PM #

    Justin breaks it down well and so what’s wrong with any investor who understands what Justin has explained investing in hybrids? Nothing. But what ASIC is rightly concerned with is the utterly unsophisticated investors in their tens of thousands that are being sold hybrids by unsophisticated or stamping fee conflicted advisers and brokers on the basis they’re just ASX listed versions of bonds and the only risk is default risk of a major bank (ignoring volatility). I’ve seen too much of this blatant behaviour to be convinced otherwise. They’re being sold as a TD alternative with a little more risk for a lot more return (a free lunch). This isn’t about complexity per se. If it was we’d be banning ETOs, CFDs, warrants and as Justin says shares. Nobody would support that. It’s about a security that has a certain position on the risk return spectrum and a high degree of complexity, but unlike its fellow complex instruments (CFDs/ETOs etc) it can be dressed up to look like it’s a Listed Note, a Listed ASX debt security for the unwitting (ASX only recently woke up and banned companies from using these terms).

    So in the complete absence of a true ASX Listed bond market, it’s not unsurprising they end up being mis-sold for years as your defensive fixed income ASX listed bond, which for the investors and advisers we’ve seen has misled them into thinking hybrids were just above TDs in risk . That’s the issue. Not complexity or well informed investors and advisers and technical analysts who know their stuff and can dissect and place hybrids in the appropriate place in portfolios. I’ve seen broker research saying this, and saying they’re negatively correlated based on some short term negative correlation when those inside the beltway know when equities fall 20% hybrids must follow by design. That’s a great team structure: your defensive players look strong and rosy when your equity forwards are scoring goals from all over the paddock (2004-2007), but go to water when your attackers go down and you need your defence to stand up and protect you the most (see Justin’s comments).

    Senior bonds have beaten equities over 10 years solely because of the GFC and the fact they’re boringly non volatile by comparison. If hybrids were fixed income, debt, or just a listed version of bonds, then they too would have outperformed equities on a mark to market basis and beaten senior bonds because of carry. They didn’t, and because they have the upside of bonds but the downside of equities, their performance since 2000 has been worse than bonds and equities. Why expect anything else from a security designed to protect the banking system or are cheap equity for the corporate issuers? They’re a sophisticated tool for the experts and should be sold as such.

    Justin points out the volatility. Senior floaters have 0.3% pa, hybrids ~6%, Equities ~15% all since 2000. They’re 20 times more volatile than floaters from the same banks and yet sold under fixed income research banners and in fixed income SMAs by brokers desperate for the stamping fees. Where’s all the broker marketing material talking about volatility compared with real fixed income or TDs? Not everyone can buy and hold to maturity. Forget mark to market, just hold to maturity. All they talk about is the fact NAB won’t fail, which of course is true, but it’s not the point if Beryl from Parramatta thinks she’s investing in a defensive conservative instrument not dissimilar to her TDs. I’ve met too many Beryls and their advisers.

    I agree with everything you said Justin for the well informed. But the masses don’t get it and haven’t been told. Want proof? Go onto ASX’s website and read how ASX’s hybrid brochure describes them: ..great alternative to TDs…and you have an equity kicker because you have an option to convert….aghh!!! sold put = bought call. If they can be fooled, then what chance the mums and dads. ASIC should be doing more than parting swipes from outgoing Chairman and the new legislation coming out will give them the power. There is a case to ban for retail and leave them for sophisticated. The Poms did it.

    • Ryan Poth August 3, 2017 at 4:43 PM #

      For full disclosure, I am a colleague of Justin’s so you may interpret my comments accordingly.

      At our firm we would NEVER market a hybrid as a TD alternative, and any adviser who does so should be ashamed. They sit, as the moniker implies, somewhere between fixed income and equities, and volatility also sits in that space (as you would expect). That is why they pay income closer to dividend yields rather than bond yields.

      The first thing I did after reading your comment was to look for that ASX brochure, which I note is relatively recent. I couldn’t believe there would be (and indeed couldn’t find) anything comparing them to TDs, so I’m guessing you were paraphrasing, but there are a few cringe-worthy statements, like:

      “Comparing a hybrid security to bonds is a bit like comparing one type of apple with a basket
      full of different types of apples and other fruit.”

      To be fair, our firm doesn’t have retail clients but I myself AM a retail investor and as such I am against regulatory mollycoddling.

      Interestingly, almost every comment I read supporting the ban of hybrids to retail investors is very similar to yours – i.e. unsophisticated investors are being misinformed of the risks by their advisers. It occurs to me that it is not the instrument itself that should be restricted, but rather the financial adviser industry that needs better oversight into bad practices and misinformed advice.

  4. Philip Carman August 3, 2017 at 3:01 PM #

    I’m afraid too few in the Money Business – especially those who are analysts and/or similarly technically minded, however expert in their area of discipline – either fully understand or properly explain the pros and cons of hybrids, nor go to the lengths of this article – more’s the pity!

    Retail investors – by definition – are “sold” investments by the retailers (whether they be advisers, brokers, analysts, etc.) and so know very little about things such as hybrids and less about the potential risks. If a retail investor was asked to answer 10 basic questions about hybrids most would be unable to do so whereas we all know what they are…don’t we? Well, actually, no. Many advisers incorrectly assess their risks and inappropriately recommend them at times. Medcraft was right, but typically a little bombastic in his description of them as “ridiculous” but anyone who’s held NABHA and experienced the extreme volatility (and they were less harsh in their fine print than many of the newer issues) would know that a 40% loss of capital in a couple of years was NOT what they were led to expect! Hybrids should be left to the professionals but they are designed (and marketed) to appeal to the Mum and Dad investors who should probably leave them well alone.

  5. Richard Murphy August 3, 2017 at 6:37 PM #

    Ryan, its on the first page of ASX’s “Understanding Hybrids”. I just checked at 6.30 so you might be looking at another ASX brochure perhaps. home page – products – hybrids – hyperlink to that brochure. I have no doubt a fixed income professional group such as Mint wouldn’t do those things I spoke about – period. And I thought Justin’s piece did the right thing. You’re right, its not the product, its how its sold. Sorting out financial advice as you say is one path, but how will that deal with the 50-60% of self directed end investors? That’s also what will be bugging GM and ASIC. The old world of the Wallace Enquiry – ‘let disclosure cure all’ is gone. That was the world we all lived in from the 90s to Murray. Treasury and ASIC have convinced Gov leading up to Murray that disclosure doesn’t cure all and so they’ve given them the banning power or are drafting the legislation now. The consultation period is over. When its enacted that means we can write what we want in a prospectus but if the channel we distribute down doesn’t have the literacy required for the product then the issuer is liable. issuers have to analyse all their channels and on their heads be it. I’m an issuer, so we had to look at this in great detail.

  6. Hybridfan August 4, 2017 at 11:29 AM #

    I note that Richard Murphy is the CEO of XTB and he should disclose that in his comments.

    The fact that Mums and Dads are the ones buying the majority of the Hybrids is false. The majority of issuance is being taken up by big institutions, super funds and professional advice firms who understand the risk. Mums and Dads will likely have exposure to Hybrids in a well managed portfolio. Mums and Dads that are unadvised and have exposure would generally have gained this exposure through the security holder issues, however compare the size of the security holder offer to the book build subscriptions.

    Christopher Joye wrote a number of hysterical articles on Hybrids and the majority of people simply quote what he wrote, here, in the press and various other subscriptions and forums. Christopher Joye called CBA Perls 9 a dud deal when the issue margin was 5.20% now he says Hybrids are cheap. The reason Joye called Perls 9 a dud was there were secondary Hybrid issues trading with higher trading margins, it was a cute argument but you could never get volume at these prices and just compare the performance now.

    In July 2015, Joye said the same thing about the Westpac Hybrid (WBCPF) except this time he said the equity was better value, the equity capital price is down 10% since that time, the hybrid capital price up 3%…so you would have been trading your capital for cashflow if you bought the equity. At that time WBC was trading on a 7.6% yield, knock off 5% a year for capital loss since that time and your return has been 2.6% p.a. Following Joye’s view on the equity being better value at that time would have been a poor investment decision. If you bought the WBCPF Hybrid at that time your return has been over 7.3%.

    Richard, on your Beryl argument, the same holds true if you buy any Bond including any XTB.

  7. Richard XTB Murphy August 4, 2017 at 3:44 PM #

    I stand unmasked. I am indeed the proud CEO of XTBs. Sorry, thought that was blatantly obvious from the range of things I spoke about. What other mug would know what an obscure ASX brochure says, as well bonds, hybrids and ASIC policy. But again Mr. Hybridfan you’re making the same point – well informed investors and advisers know their stuff. Totally agree. It would be interesting to see some data on who actually buys hybrids as I’d still be very surprised if two legged investors were not the majority of investors in the issues that aren’t mainly distributed OTC or offshore. And please God oh please God can Mr. Hybridfan be your real name!! Someone will finally knock Citibank trader Robbie Risk, off his perch as the best name in the securities industry.

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