ASIC’s Moneysmart website has a good summary of the features and risks of investing in listed Hybrid securities and is something you should read if you are considering investing in the product.
A link to the website can be found here. (https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes).
A hybrid is like a bond – it typically promises to pay interest at a fixed rate or a floating rate over a period of time into the future. The main reason to invest in Hybrids is that these securities currently pay (in the case of major bank issued hybrids) up to 3.7% above the 90-day bank bill rate (currently 2.08%) for a total floating rate return of about 5.78%. The 90-day bank bill rate varies but the margin of 3.70% (for example) is fixed on the day the security is issued.
A floating rate means that if interest rates rise you get paid more, but if interest rates falls you get paid less. The price of the hybrid does fluctuate but the volatility is not near as much as the underlying share price. For example, the volatility of CBA for 2018 was 16.64%, but the volatility for the CBA hybrid (CBAPD) was 4.23%.
Investment features and returns often depend on whether a ‘trigger event’ occurs.
Trigger events include:
- a loss of earnings causing the deferral of interest payments
- a change in the capital levels of the issuer resulting in a conversion to equity
- a change in tax laws or regulatory requirements which may give the company the right to repay the hybrid early or much later than expected.
The issuing company may have limited control over these trigger events, but they can significantly affect how the investment behaves or whether you get the payments you expect. These events can be difficult to predict.
Liquidity Risk – hybrids are less liquid than shares. Hybrids are issued by major banks, other banks and corporates, with the major bank securities being the more liquid security.
Hybrid securities are generally unsecured, meaning it is not secured over any assets. In a windup you will usually rank behind senior bondholders and other creditors, but ahead of the shareholders.
Hybrid securities are issued because they can count as a form of capital. They can count it as capital because if they run into financial difficulty, in certain circumstances, the hybrids can be converted in ordinary shares. This means that, clearly, you can lose all or part of your capital.
Hybrids are a complex investment product. Let’s look at an example of the risks involved by looking at the recent CBA hybrid (CBAPH) issued on 17th December 2018. Please refer to the attached CommBank PERLS XI Prospectus for a complete description of risks.
Distributions are paid quarterly and the payments are expected to be fully franked. If they are not fully franked, a cash adjustment will be made to compensate. Payments are made subject to the absolute discretion of CBA, that the payment does not result in the bank breaching its capital requirements, that the payments will not result in the bank becoming insolvent and APRA does not object to the payment.
Distributions that are not paid do not accrue and will not be subsequently paid. The non-payment will not be an event of default, but CBA will not be able to pay a dividend on ordinary shares or return any capital or undertake any buy-backs or re-purchases on ordinary shares.
When will the Face Value be repaid?
CBA has the right to redeem, at face value, some or all PERLS XI on the first Call Date of 26th April 2024. APRA needs to approve the payment, which may or may not be given. This date is generally the date the market uses as a presumed maturity date for purposes of day-to-day valuation and trading. Circumstances may lead to this date changing. The bank may also redeem the securities if it is unable to pay franked distributions or for other regulatory reasons.
Holders do not have any early redemption rights. Your only option is to sell at the prevailing market price.
If the securities are not redeemed on the first Call Date of 26th April 2024, the next major date is the Mandatory Exchange Date on 26th April 2026 (two years later).
CBA will issue you $100 worth of shares (subject to some conditions) at a 1% discount. The idea is that you can sell these shares on market to redeem cash. CBA will use a share price of the 20-day VWAP, at the time, subject to a minimum share price.
The minimum share price was established on the issue date of 17th December 2018. The VWAP on issue date was about $70.35 (called Issue Date VWAP). The minimum share price is 50% of this value => $35.18. Anything above $35.18 will be a normal calculation, anything below uses $35.18. Other words, if the CBA share price at the time is $30 you will still pay $35.18, and in effect you will incur a capital loss.
The conditions for a Mandatory Exchange to occur is if, 25 business days before 24th April 2026, the VWAP needs to be greater than 56% of Issue Date VWAP, i.e above $39.40.
If that first Mandatory test is not satisfied, the Second Mandatory condition is if the then share price, on 26th April 2026, is more than 50.51% of Issue Date VWAP.
The third Mandatory condition is that the Ordinary shares are listed on the ASX.
Notwithstanding all the mandatory conditions above, an automatic exchange can occur at any time, negating the Mandatory conditions, if a Capital Trigger Event occurs or if a Non-Viability trigger occurs.
Under Automatic Exchange you will receive $100 worth of shares at the current share price (5-day VWAP) with the benefit of a 1% discount.
The maximum number of shares you will receive will be based on 20% of Issue Day VWAP (20% of 70.35 or $14.07). Other words if the share price is below $14.07 then you will receive less than $100 worth of share, incurring a capital loss.
A Capital Trigger Event occurs when the CBA Level 1 or 2 capital ratio falls below 5.125%. As at 30th June 2018, CBA Level 2 capital ratio was 10.1% and the Level 1 capital ratio was 10.8%.
In the event a Capital Trigger occurs, CBA is required to exchange all or some of the Perls XI into shares, to bring back the Capital Ratio above 5.125%. If for any reason CBA is prevented by law, court action or action by Government authority, to issue Ordinary shares, your investment will lose all its value and you will not receive any compensation.
Hopefully you can appreciate that given all the above, Hybrids securities are not a simple product where your rate of return can be compared to a fixed term deposit or a Government Bond.
The reason you get a higher return is that you are taking on a higher level of risk. A key assessment may be whether you believe the current share prices can fall by 50% or more. You need to assess whether, on balance, the increased risk is compensated by the increased return.
For anyone interest, we are running a webcast on Hybrid securities this Thursday (31st January) at 7pm, where will cover the above and other risks of investing in Hybrids. Please register here