Hybrid Securities – appropriate for dividend investors?
What are Hybrid Securities?
Hybrid securities are a broad class of instruments encompassing subordinated notes, capital notes and convertible preference shares in Australia. These securities sit higher in the capital structure than normal equity and blend features of both debt instruments and equities. Currently, the Australian market is seeing a number of new hybrids marketed as previous hybrids reach term and come due. In particular, capital adequacy rules outlined in Basel agreements have seen Australian banks issuing hybrids to increase capital ratios.
Debt, or Equity? Well….
Rather than outline my thoughts, I think I’ll defer to the godfather of fundamental investing, Benjamin Graham, who said:
“Really good preferred securities can and do exist, but they are good in spite of their investment form, which is an inherently bad one … the preferred holder lacks both the legal claim of the bondholder and the profit possibilities of the common shareholder.”
Further, he goes on to say:
“Many investors buy securities of this kind because they need income and cannot get along with the meagre returns offered by top grade (investment grade) issuers. Experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate safety merely because the yield is attractive.”
This is such an important point and often undersold when talking about hybrid securities. In the same way that you shouldn’t reach for yield (at the expense of growth) when selecting dividend stocks, you should also not be reaching for yield in other instruments.
So, why would anyone buy them?
Again, Ben Graham has some wisdom for us:
“Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity … in other words, they should be bought on bargain basis or not at all.”
In Australia, we haven’t seen “adversity” in the hybrid market since 2007-2008. The chart below clearly shows the effect that the GFC had on hybrid pricing.
And here in this chart lies the crux of the problem – hybrids, in times of normalcy, offer bond like returns and equity like risks. The securities generally contain clauses favourable to issuers at the expense of investors. An investor who is considering an investment in hybrid securities must be prepared to both read and understand these clauses (particularly conversion clauses) before considering an investment in these securities.
Of particular importance are capital adequacy and non-viability triggers. In times of severe stress, new hybrid instruments (known as Contingent Convertibles, or Additional Tier 1 securities) will be converted into equity in order to act as a first line of defence, and to allow an “orderly” resolution to banking stress. This is highly likely to involve hybrid owners suffering significant capital losses. In some cases, these securities may even be converted and suffer losses before common equity!
Why I prefer equities to hybrid securities:
I follow a two pillar model for buying securities – the first pillar is valuation and the second is dividend quality. As part of dividend quality, I focus on stocks that not only deliver attractive yields but have prospects for growing those yields sustainably over time. Hybrid yields are stagnant – they will not grow, regardless of the prosperity of the underlying business. Unless there is a significant sell-off market wide and hybrids look attractive during the sell-off, I will be focusing on equities for the foreseeable future.
Do you have holdings in hybrid securities? Let me know in the comments!
(Disclaimer: The information in this piece is personal opinion and should not be interpreted as professional investment advice. The author makes no representations as to the accuracy, completeness, suitability, or validity of any of the information presented. As always, seek professional advice.)