SMSFundamentals: Hybrid Power

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

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Energy company and coal seam LNG developer Origin Energy ((ORG)) recently announced it was raising funds not by issuing new equity, or by issuing debt, but by issuing what's known as a "hybrid security". Origin's underwriters were flooded with applications from both institutional and retail investors who are hiding from the volatile stock market but are looking for opportunities to generate a decent yield without the risks inherent in a dividend paying stock, but with greater reward than the conservative term deposit or cash management trust their money is currently sitting in.

Recently supermarket leader Woolworths ((WOW)) issued a hybrid of its own which was also well oversubscribed and is now listed on the ASX  (ticker: WOWHC). Currently there are dozens of hybrid security listed on the ASX, representing everything from banks to media companies and hospital managers. In this world of investment uncertainty, Australian hybrid securities — which were once eschewed by investors for being too complicated and too illiquid —  are flavour of the month.

What are hybrid securities and why might they suit a smurf's investment portfolio?

To discuss these questions FNArena has enlisted the assistance of Australian hybrid specialist Gamma Wealth Management.

Prologue

By Greg Peel

A hybrid engine, such as the one in Toyota's famous Prius, combines both petrol and electric power. Despite the combination, however, only one power source is driving the car at any one time. The fact that there are two power sources available in one car nevertheless provides for a combination of fuel efficiency and “greenness” on the one hand, and range and requisite oomph when needed on the other, and the vehicle's price represents that flexibility.

A hybrid security is a combination of debt and equity. Like the hybrid engine, a hybrid security is never debt and equity at the same time, but because both are available to the investor given certain circumstances, a hybrid security is priced based on that flexibility of style of investment.

If we take standard debt to be a bond and standard equity to be a stock, we can compare the various characteristics.

A common or garden bond is issued at a specified “face value” which is usually $100 and typically offers a predetermined coupon payment, let's say for the sake of argument 10%. When you buy a company's bond you are effectively lending that company money which you expect to get back at the maturity date. In between, the company regularly pays you the interest on the loan (coupon). So for a five-year bond, for example, you'd get your $100 back in five years plus five payments of 10% in the interim or $50 in total.

You are never going to make any more than $50 net profit, but you know for sure you will make $50 net profit provided (a) the company doesn't go broke before maturity and (b) it is always able to pay its coupons. If you're confident a company can do both, which you probably would be for a Big Four bank say, then a bond is a low risk-low reward investment instrument. If you're not completely confident but the coupon payment is much higher to compensate for that risk, then the risk-reward equation simply needs weighing up. At the very least, if the company is wound up you will be in line for some recourse head of any shareholder in the company.

Which brings us to equity. You can buy shares in a company on issue at whatever price the company deems to issue them at and you might receive dividends at some time or you might not. Unlike a coupon, the company is not obliged to pay a dividend even if it can, and payments can rise and fall over time. A share never reaches a maturity date like a bond does. Either it carries on for decades or the company buys back the shares and de-lists or another company takes over those shares or the company simply goes broke. Otherwise, the only way to exit the shares is to sell them. You cannot, unlike a bond, have any specific idea of what your investment might be worth in five years time.

Shares are therefore a lot more risky than bonds, but unlike bonds they offer “blue sky” upside in value whereas bonds have a predetermined value at maturity. Shares thus offer a higher risk-reward balance because you are an investor in the company rather than a lender of money to the company. Shareholders are thus last in line if a company is wound up.

While a diversified investment portfolio may contain both debt and equity instruments, an investor is usually more inclined to lean towards debt in a riskier and more volatile trading environment and towards equity in a more stable and promising investment environment. Episodes like the GFC saw, for example, Australian bank shares slammed but no one really assumed one of the Big Four would go out of business. Hence while the value of Big Four bonds also fell to reflect increased risk (for which you would otherwise expect a higher coupon), they did not fall by as much as the value of the same bank's shares because final payment at maturity was still assumed. What bonds lose on the swings of limited value upside they gain on the roundabout of limited value downside. On the other hand, back in 2004-07 when share market returns were averaging 20% per year a bond investor would have been missing out on the spoils. It would be great if an investor knew ahead of time whether markets were going to be stable and strong or weak and volatile because then that investor would choose an appropriate balance of debt and equity investment at the outset. But of course, an investor never quite knows.

What would be really good is if there were one investment that could be a sort of “horses for courses”. The Toyota Prius offers a cheap little city runabout that's great in the traffic (electric motor) but when needed can provide longer distance range or a spurt of acceleration at appropriate times (petrol). Imagine if you could have an investment security that offered the safety of a bond when times are scary but the upside of a stock when times are bountiful.

Ah hah!

Welcome to the hybrid security. It is wrong to say “a typical hybrid security is…” because in this day and age there is no such thing. Once upon a time there were pretty much just two forms, known as the “convertible bond” and the “converting preference share” which had slightly different but otherwise similar characteristics. Despite the word “share” in “preference share”, this instrument still started life as a bond. Today, however, hybrid securities come in so many different shapes and sizes that there no longer is a “generic” form, and indeed it's difficult to find any two hybrid issues which offer exactly the same characteristics. They may be convertible or converting, redeemable or redeeming. They may reset or "step up", they might be perpetual, their coupon could be fixed or floating or at a fixed spread over floating. They may get converted/redeemed by the investor before maturity or perhaps by the issuer. They may pay back face value, or some other value, or a value determined by the company's share price at the time. They may have all sorts of bells and whistles.

But underneath all of that will be one straight forward characteristic. They will be a bond (debt) with a share option (equity) attached. In pretty much all cases, hybrids start life as a bond at whatever the corresponding share price is now and change into an equity only if the share price rallies by a certain amount. The point is that if the share price rallies strongly, you as the investor want shares, not bonds. If the share price doesn't rally and indeed scarily falls, you want bonds, not shares. This is what a hybrid security offers the investor. Although the rule of thumb is you only get one chance to switch (which may even be the company's choice, not yours) and you can't then go back again. Most (but not all) hybrids have a maturity date of some description anyway.

Companies can choose whether they prefer to raise the funds they need by borrowing money (issuing debt) or by bringing in investors (issuing shares). A diversified balance sheet will exploit both. Pure equity is cheaper but dilutes value directly while pure debt is more expensive but doesn't dilute value directly. It can even enhance value if it means the company now has the funds to make those widgets it knows it can sell, for example. Thus for the issuer, a hybrid security also offers a balance. At first the company is issuing debt so there's no dilution. If those bond holders later convert to equity at the higher share price there will be dilution, but if the share price is higher then who cares? And given the buyer of the hybrid is keen to pay for that imbedded share option, the coupon the company has to offer can be less than if the security were straight debt.

Everybody wins.

I will now hand the microphone over to Gamma Wealth Management to provide some more specific details about investing in hybrid securities.

1. What are hybrid securities?

Hybrid securities combine the elements of debt and equity – hence the name hybrids. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the investor(holder) has several options at maturity. Such investments are popular with retirees and self managed superannuation funds seeking higher yields and taking advantage of franking credits (where applicable). They are often an attractive alternative to term deposits and cash accounts.

As with most investments, riskier hybrids pay a higher interest payment (otherwise called a coupon or preferred dividend) to compensate investors for the added risk.

2. Risks of hybrid securities

Risk of losing capital – if the issuer’s share price falls dramatically then the hybrid securities are likely to lose capital value. Even worse if the issuer goes broke, hybrid investors are unlikely to see a return in a liquidation of the company however under most circumstances the hybrid securities rank higher than ordinary shareholders in the case of a company liquidation.

Distributions suspended – the other main risk is that the issuer may suspend distributions on the security. Issuers may suspend distributions on their hybrids, usually at the behest of the company's banks looking to safeguard their position. Currently, the hybrid issued by Elders (ELDPA) is suspended although it is forecast to be reinstated in the last quarter of 2011.

Conversion issues – usually the conversion conditions are dictated by the issuer and on occasions these terms may be detrimental to the investor.
Interest Rate Movements – interest rate movements may affect the return on the hybrid security.

3. Why do companies issue hybrid securities?

When buying a hybrid security you are typically lending money to a corporation. They are commonly known as the issuer. In return for the loan, the issuer pays a given interest rate (called the coupon) for the life of the security, usually repaying the principal at maturity.

The major reason why companies issue them is because it can sometimes be a cheaper alternative for funding (raising capital) and also because companies may be able to utilize the franking credits on their balance sheet to pay out distributions to holders of the securities.

4. Characteristics of hybrid securities

The main components of a hybrid security are:

The Face Value (initial principal investment or capital amount) is usually the amount repayable to the investor at maturity. Usually, most securities are issued at a face value of $100. Once they are listed on the ASX then the secondary market price may vary from the face value during the term of the security. Just like an ordinary share an investor can trade these securities.

Interest on the face value, which accumulates at a predetermined rate referred to as the coupon. This can be fixed (for the term) or floating based upon a particular benchmark (e.g. 90 day Bank Bill Rate or 5 year government bond).

Maturity date is the date the security expires and principal is either repaid or, in the case of selected hybrid securities, converts to ordinary shares (which is known as the conversion date).

Conversion ratio is the ratio of shares offered for each converting security. This may be a fixed ratio (for example 1:1) or at a discount or premium to the market price. For example, converted at a 2% discount to the ordinary share price.

Nominal yield is the pre determined interest income calculated as a percentage of the face value.

Yield to maturity is the interest income calculated as a percentage of the current market price of the security and the time value until maturity.

5. What are the factors to consider when choosing a hybrid security?

Future Interest Rate Movements

Potential movements in interest rates will affect whether the investor considers floating rate securities or fixed rate securities. Many investors like fixed rate securities because there is a fixed and certain amount of distribution paid at regular intervals however in a rising interest rate environment fixed rate hybrids may be less attractive because the rate of return is not increasing in line with interest rate movements. Fixed rate issues that have been well supported in the marketplace are Macquarie Convertible Preference Shares (ASX Code: MQCPA – 11.1% fixed) and Heritage Building Society Notes (ASX Code: HBSHA – 10.0% fixed)
.
Credit rating

Credit ratings can assist potential investors to form a view of the creditworthiness of the corporation and compare them with other similar assets across different corporations. In general a AAA rated hybrid security will offer a lower rate of return while a lower rated hybrid security will offer a higher rate of return.

Margin

Margin is the spread over a certain reference rate that a hybrid is trading. This is in effect the running yield expressed in terms of a margin over bank bills. If the hybrid security pays a floating rate, the reference rate is usually the 90 day or 180 day BBSW (Bank Bill Swap Rate). In general, the lower the credit rating of the company, the higher the margin over the reference rate the issuer has to pay to entice investor to hold their securities.

Running yield

This is the yield of the security based on its market value.

Duration to conversion, step up or redemption

Once issued there is a point where the hybrid is reset for conversion, redemption or a distribution step-up.

Liquidity

The liquidity of the hybrid securities is often directly correlated to the credit rating and size of the issuing company. Generally the larger the hybrid issue the closer it tends to trade to fair value and generally more securities are traded in volume than smaller issues.

Frequency of dividend payment

Most of the floating rate hybrids either pay income quarterly or semi-annually. There should be a slight preference for investors to seek those hybrids that pay quarterly distributions as the income can be compounded. As previously outlined in a rising interest rate environment having a floating rate hybrid security is more advantageous.

Balance sheet

One of the most important parameters with respect to a hybrid security is the amount of debt that a company is carrying. The lower the net debt to equity ratio, the higher probability the hybrid will not suffer from capital loss due to it trading as a debt-type security.

The reputation of the corporation

The well established corporations and household names are often better at providing regular distributions to investors and they generally provide lower risk to the investor.

6. Potential growth in the hybrid market and upcoming issues

The Federal Government introduced a government guarantee for deposits in Authorised Deposit-Taking Institutions (ADIs) up to $1 million. The Government is currently reviewing the $1 million cap to determine an appropriate level at which it should be set from October 12, 2011. Any potential changes to this level i.e. being reduced to $250,000 or $100,000 guarantee from $1million may encourage investors to pull their funds out of the term deposits and cash accounts and look at other investment alternatives to obtain income. The Hybrid securities may benefit from these changes.

Companies may also look to issue more hybrid securities because they want to be better capitalise their balance sheets in these uncertain times. The four major banks in Australia are also required to meet certain capital requirements so therefore they may need to issue more hybrid securities.

Epilogue

By Greg Peel

Given that no one can honestly tell you which way financial markets are going to move over the next week, or month, or year, there is no reason why hybrid securities can't be a valuable risk-reward instrument to be included in any investment portfolio at any time. Right now hybrids have found renewed popularity given the frustrating uncertainty of a post GFC world dominated by sovereign debt problems.

In bull markets, a so-called “balanced” portfolio might have 5% invested in cash. Today however, FNArena surveys find that investors are holding 25% or more in cash, often in the form of the boring old bank term deposit. Those that are game enough to venture into the stock market are trying to keep away from too much risk and looking for solid and reliable dividend payers such as banks, utilities or other service companies for example that may not offer much in the way of screaming share price upside potential but at least offer a decent income, which of course is very important for the self-managed retiree in particular.

Perhaps the best way to appreciate the potential value to the investor of a hybrid instrument is to compare a hybrid and the underlying share of the same company. The following chart does so for Macquarie Group ((MQG)) shares and a Macquarie listed hybrid. The share price is in black and the hybrid price in blue:

These are price graphs only and do not account for either dividends paid on the share or coupons on the hybrid but obviously markets factor the value of those distributions into prices. As a rule of thumb, companies will offer hybrid coupons at levels higher than corresponding dividends (in yield terms) given debt is more expensive than equity. Note however that subsequent share price movements can send prevailing stock yields to level higher than hybrid coupons but only after a fall in the value of the stock. Note also the above discussion of franking credit considerations.

Here is another example, this time ANZ Bank ((ANZ)), and this time with the share price in blue and the price of an ANZ hybrid issue in pink:

Both these charts demonstrate that while the price of a hybrid security will be impacted by the price of the underlying share, its downside is more limited.

Note, however, that were the circumstances reversed such that bank shares were suddenly flying to the moon once more, the share price lines would cross over the hybrid price lines and begin to outperform. It is here that a hybrid really shows its stripes because at some point those debt instruments will be convertible or converted into ordinary shares.

As further illustration, here are a couple of tables provided by Gamma Wealth Management outlining the characteristics of just a handful of hybrids currently listed on the ASX. Note please that the risk rating is the opinion of Gamma Wealth Management.

(Please note prices displayed are recent but not up to date at the time of publication. Note also that CBA Perls are issued with a face value of $200, not $100 as is the case with the other listings.)

It is very important for investors to note, nevertheless, that hybrid issues are not simply by their nature a win-win investment. All hybrid issues are usually different in structure and terms and conditions can run to hundreds of pages of required disclosure. Buried therein might just be the clause that renders a particular hybrid more of a case of equity risk with only bond returns, rather than bond risk with potential equity rewards. ASIC has felt it necessary to post an official warning to investors that it is paramount to understand and appreciate the vagaries of different hybrid issues and their risks before considering an investment.

FNArena strongly recommends that investors interested in hybrid securities first contact their broker or financial adviser before making an investment decision. Please be fully appreciative that hybrids are complex financial instruments with extensive and often unique characteristics that need to be fully understood by the investor and, indeed, by the investor's adviser.

Gamma Wealth Management is a specialist in hybrid and other interest rate instruments but there are other firms investors can turn to.

Readers can contact Gamma Wealth Management at info@gammawealth.com.au to register interest in hybrid securities and any future offerings. Otherwise visit their website at  www.gammawealth.com.au.

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