What are Hybrid Securities?
Hybrid securities are securities that contain characteristics of both debt and equity securities. These securities sit below debt in the capital structure but above common equity, and pay a predetermined (generally floating in Australia) distribution or dividend until a certain date
No two hybrids are the same – the number of clauses found in the prospectuses of these securities can be incredibly daunting.
The primary features of hybrid securities are:
- Subordinated to normal debt
- In a wind-up, hybrids sit above equity but below other debt in line for recovery.
- Distributions may be deferrable
- Deferral of distributions falls into two categories – either optional or mandatory (in the event of a covenant breach).
- They pay a predetermined rate of return, either fixed or floating.
- They have loss absorption provisions that require security holders to absorb losses
Types of Hybrid Securities
There are four main types of hybrid securities. In order of most debt like to most equity like, they are:
- Subordinated debt. Subordinated debt are long dated debt securities, with some equity like terms. These terms are generally subordination, coupon deferral clauses and loss absorption provisions.
- Perpetual Securities. These are essentially securities without a maturity. The issuer retains the right to redeem the securities at certain stages of their life, but the are not obligated to do so.
- Convertible Preference Shares. These are so named because they receive preference over common equity for distributions and the repayment of principal. There is no maturity date – rather they have optional and scheduled conversion dates, provided certain conditions are met.
- Capital Notes. Capital notes are similar to Convertible Preference Shares. Capital notes have been issued by financial institutions in order to meet the requirements as tier 1 capital.
Trends in Hybrid Issuance
Over time, the issuance of hybrids has seen the characteristics of these securities move from more debt like to more equity like. This is primarily a result of issuers attempting to meet strict requirements from both regulators and ratings agencies.
In January 2013, new regulations were introduced by the Basel Committee (“Basel III”) that resulted in additional requirements for securities to be classified as “additional tier 1 capital”. These new requirements have increased the risk of loss of capital in times of distress, the risk of conversion into equity, the risk of not receiving distributions and greater price volatility.
What’s a Coco?
Contingent Convertible securities, also know as bail-in securities or Additional Tier 1 Securities, have become the largest part of hybrid issuance since 2013. They are mandatorily convertible into an issuer’s common equity at a certain point in time, provided some conditions are met.
CoCo’s typically contain an issuer call option to redeem the securities for cash (almost always at par value). This is typically two years before mandatory conversion. In Australia, all securities have thus far been called prior to mandator conversion.
CoCo’s also typically contain two vital clauses: a regulatory capital trigger and a non-viability trigger. Should capital fall below a pre-defined level (typically 5.125%), the securities will be converted into equity. The Australian Prudential Regulation Authority (APRA) are able to declare a financial institution non-viable; in this case, the securities will also be converted into equity.
The amount of shares received in these scenarios is capped, ensuring that investors in hybrids absorb some of the losses when a financial institution is in distress.
That Sounds Dangerous?
It is dangerous! In fact, there have been a number of warnings from regulatory bodies about the dangers inherent in these securities. Heare are some of my favourites:
Professor Kevin Davis – Australian Centre for Financial Studies:
Extremely complex and difficult to value securities… The ability of retail investors to assess the likely future outcomes – the risk/reward – is questionable
Wayne Byers – APRA Chairman:
Viewing hybrids as “higher yielding substitutes for vanilla fixed-investments, let alone deposits, is something to be counselled against”.
It is important for investors to understand that bank hybrids are designed specifically to allow for an “orderly resolution” in the event of non-viability or capital inadequacy of a financial institution
UK Regulator, Financial Conduct Authority:
CoCos are highly complex and the FCA believes they are unlikely to be appropriate for the mass retail market
Standard and Poors:
Following a review in September 2014, S&P downgraded the credit ratings of approximately 80% of post-Basel III hybrids, noting that the instruments are more equity like than previously thought
These are the companies and regulators primarily responsible for these instruments. In APRA’s case, they are also in charge of determining non-viability of financial institutions. It is somewhat concerning to hear My Byers say that hybrid securities may be junior to common equity if required to facilitate and orderly resolution of a banking crisis!
What Happened to Corporate Issuance?
In 2012, ratings agencies issued guidance that indicated corporate hybrid securities would no longer be counted as 100% equity capital. Given the large part of corporate issuance was undertaken in order to avoid the negative effect of excessive debt, hybrids have become less attractive to non-financial issuers.
In addition, the Australian corporate debt market has become more liquid over time. When combined with a cheap cost of debt, hybrids are a far less attractive option for raising capital.
Given the large amount of clauses, there are a number of areas that investors need to be aware of when considering investments in hybrid securities.
Dividends can be cumulative or non-cumulative and deferrable. If the company can defer distributions, an investor benefits from the missed distributions being cumulative (as opposed to non-cumulative). It is also important that if hybrids do not receive distribtuions, then distributions cannot be made to common equity – this is know as a dividend stopper.
Australian investors should also consider whether the dividends are franked or unfranked,. For investors that can use franking credits, a better measure of yield is the grossed up yield.
Call Options and Conversion dates:
Investors should be aware of an issuer’s ability to call securities. While increasingly investors have been conditioned to expect redemption on the first call date, in my opinion investors should not consider this a certainty. You should also be aware that the issuers right to redeem is beneficial to the issuer, not to the holder – if not redeeming is in the issuers best interests, then the security won’t be redeemed.
Issuers also have a right to convert hybrid securities into equity. Again, this is at the issuers option, and it is highly unlikely that this would be enacted if receiving shares in the underlying stock was in the investors best interest!
Securities will be automatically converted into shares if the share price is above a nominated hurdle. Receiving shares may not suit investors, as per most conversion clauses.
Ranking on Liquidation:
Subordinated debt ranks above ordinary equity and preference shares. Preference shares rank above ordinary equity only. Many hybrids will convert into ordinary equity on liquidation and this increases the chances of investors losing all of their capital in the event of a liquidation.
Capital trigger: APRA requires that when a capital trigger is breached, hybrids convert into equity. If this occurs, 100% losses are likely.
Non-viability trigger: A new clause which is so far untested. Designed to provide loss absorbing capital for a non-viable financial institution, it is highly likely that in the event an issuer is deemed non-viable, investors in hybrid securities will suffer a 100% capital loss.
Who are buying hybrids in Australia?
Perhaps tellingly, hybrid securities until recently have been the domain of the retail investor. It reminds me of an old saying – “financial products are sold, not bought”. Within retail investors, investment in hybrid securities is concentrated within Self Managed Super Funds (SMSFs), which benefit from the higher yields available and the ability to utilise franking credits.
Institutions have typically not been active in the hybrid sector, with franking credits not able to be reported as performance (which leads to a situation whereby securities higher on the capital structure deliver “better” returns than hybrids). There has been some institutional support at the right prices for more recently issued hybrids.
Why are retail investors attracted to hybrids?
- Higher rates of returns – Hybrid securities offer higher yields compared to senior debt, reflecting their position on the capital structure.
- Liquidity benefits – Listed on the ASX, hybrids can be traded in the same was as shares. Although liquidity is not typically high (which can lead to large buy/sell spreads), investors can liquidate within 3 days.
- Income at lower price volatility than equity – hybrids pay well defined and regular dividends while axcting similar to low volatility equities.
- Diversification beenfits. – theses securities can diversify the overall portfolio risk, although I am sceptical that these securities will act like this in times of financial stress.
Should I Invest in Hybrid securities?
I have written on this before. In my opinion, some hybrids may provide attractive opportunities during significant market dislocations. I do not think that the increase in yield over equity properly compensates for the lack of prospects for capital appreciation. My preference remains for high quality dividend growth stocks, although hybrid securities may be appropriate for some investors in some situations.