Sharemarket volatility strengthens case to consider hybrids in portfolios.

Amidst the enduring search for yield, Australian investors who have typically maintained high allocations to Australian shares and cash in their portfolio, continue to utilise the ASX Listed Hybrid Securities market as a means of further diversifying their portfolios. 

(Editor’s note: It is important to understand the features of hybrids, which have some equity-like risks and benefits. Hybrids are generally more complex in nature and may have higher risks than other forms of investments. Always seek independent advice before using hybrids.)

Investors access hybrids as a way of enhancing the probability of achieving their income objectives over time. Individual investors, within and outside of superannuation, as well as institutional investors, have considered hybrid securities as a differentiated source of income.

This year has been particularly challenging as investors have had to navigate volatile investment markets and a declining interest-rate environment.

This has made the inclusion of hybrid securities in investment portfolios more pertinent, particularly as they have continued to pay their dividends while ordinary bank-share dividends have been reduced or even omitted, in some cases. 

Understanding hybrids

Hybrid securities have both debt- and equity-like features and characteristics. It is important to note they are neither true debt nor true equity securities. 

Hybrids are frequently issued by banks, insurance companies and large ASX-listed companies. They generally provide higher yields than debt securities to compensate for the higher investment risk. 

Hybrid securities pay a regular fixed or, in most cases, floating rate of return or dividend (which generally includes franking credits) until a certain date. 

Being a dividend, this payment is always at the issuer’s discretion, and as we have seen lately, also at the discretion of the regulator (Australian Prudential Regulation Authority). 

However, hybrids include a dividend stopper, meaning their dividend must be paid in full if the company pays any dividend on its ordinary shares. 

This year, we have seen that APRA is comfortable for banks to continue paying hybrid dividends even when they do not pay dividends on their ordinary shares. 

While on issue, the following scenarios may occur, subject to APRA approval:

• the issuer may convert, redeem or resell the securities at the first optional call date.
• if left on issue, the securities are scheduled to convert at mandatory conversion into $101 worth of shares, providing certain conversion conditions are met. The mandatory conversion date is normally two years after the optional call date. 

In all but a couple of instances, the issuer has effectively redeemed or resold the securities at the optional call date while offering the ability for the investor to choose to re-invest into a new issue. 

COVID-19 and hybrids

The volatility and subsequent liquidation of securities to raise cash that occurred as COVID-19 hit in March/April was unusual. 

While hybrids were not spared from this indiscriminate selling, liquidity in the hybrid market increased substantially as sellers raised cash, while investors who understood the risk-and-return attributes of hybrids took advantage of “knock-down” prices and higher than usual implied rates of return. 

During the second half of the year, we saw strong buying in the hybrids by a range of investors, which pushed up prices and reduced the expected rates of return to levels last seen in January this year, prior to the COVID-19 impact. 

A big driver of the recovery has been the contraction in the yield spread between bank shares and hybrids, as banks cut dividends on ordinary shares but maintained dividends on their hybrids.

A broader dynamic has also been the allocation away from equities into hybrids, given the increased volatility in equities. 

Furthermore, hybrids received a greater allocation in cash and interest-bearing investments (term deposits and bonds) from investors who were comfortable to take on the additional risks of hybrids to generate higher returns. 

By building and managing well-diversified portfolios, investors can achieve their risk-and- return objectives. 

Yield more attractive as rates falls

Investors with a shorter investment horizon might prefer a blend of short-dated (less than two years) securities issued only by the four major banks. 

Others who are happy to allocate to this asset class over a longer time horizon invest in longer-dated securities to generate a higher return over time.

During the year, the RBA cash rate fell from 0.75% to 0.10%. The 90-day bank bill swap rate, used to determine the floating-rate hybrid distribution, also fell significantly from 0.92% in late December 2019 to 0.2% currently. 

Although this means the overall income return generated from hybrid securities has fallen over the year, it is the margin that these securities pay over this benchmark rate that has added to the attractiveness of the interest payment. 

To illustrate this, consider the average margin of a major bank 5-year security at around 3.30%, which results in an expected yield to the 5-year call date of 3.63%. This means the additional income generated over and above the lower benchmark is proportionally higher than in previous years when interest rates were higher. 

Floating distributions also mean that, in theory, hybrid prices are less volatile than if they were paying a fixed-rate distribution (fixed-rate securities’ capital value falls as interest rates move higher). 

As the RBA’s recent minutes indicate, interest rates will stay low for at least three years, which will likely see ongoing demand for hybrids from new investors, resulting in tighter margins as prices rise.

New issuance

One of the major drivers of the hybrid market is the pipeline for new issuance. As hybrids approach their first call date, the issuer is expected to redeem or repurchase the security and offer a re-investment security. 

This is a replacement security with a new expected call date and new issue margin, which is determined by the prevailing demand-and-supply conditions. 

In April this year, one of the main reasons for the substantial buying in hybrids was that there were no calls due for the major banks until mid-December this year, which generated buying in the secondary market. 

In October, there were replacement transactions and in mid-November, Westpac (ASX:WBC) and National Australia Bank (ASX:NAB) came to market with new hybrid issuances, adding much-needed primary supply to the market.

Approaching Christmas and the New Year, liquidity tends to diminish. We also see some portfolio reallocation as the settlement of the recent hybrid issues takes place, with sales of some existing hybrid securities occurring to facilitate the purchase of the newly issued ones.  

New issues normally offer a concession that acts as an incentive to buy the new issue over existing securities. 

We have also observed investors buying attractively priced hybrids in the secondary market, driven by the heavy scaling of new issue allocations due to the quantum of demand into these new hybrid issues. 

Going into 2021, we expect the environment of persistent low interest rates, high volatility and lack of new issuance to contribute to a strong hybrid market.