Interest rate securities - also known as hybrids - are exchange-traded instruments that combine some of the features of equity securities with some of the features of debt securities.
Typically, they more closely resemble a debt instrument at the time of issuance but may convert into equity at a pre-determined time in the future or if certain conditions are satisfied. It is essential to understand that not all instruments have the same terms and conditions; therefore, careful consideration of each security is recommended.
Thomas & Co offers accessible, plain language summaries of key terms for each security under research coverage.
Hybrid Securities for diversification
Interest rate securities can be a valuable addition to a portfolio where, for example, volatility in the equity market has increased an investor’s level of risk aversion. Alternatively, conservative investors grappling with low-interest rates can incrementally improve expected returns by incorporating interest rate securities into their strategy.
Hybrids combine both 'equity-like' and 'debt-like' features. Some of the comparisons to shares and bonds include:
- Accessibility: Hybrid securities can be sold on the secondary market. Investors can also reinvest existing holdings or purchase securities when an issuer launches new money offers
- Steady income stream: Shares pay dividends at the company's discretion. Similarly, distributions on hybrids are made at the discretion of the issuer.
- Investment timeframe: Like bonds, hybrid securities are typically issued with scheduled call dates, but generally, these securities can be left to trade into perpetuity or may be converted to ordinary shares in some circumstances.
- Early redemption: Like bonds, a hybrid issuer may repay the security by repaying the principal or converting the hybrids to ordinary shares.
- Subordination: In a wind-up scenario, who will only repay holders of hybrid securities once lenders, bondholders, or other higher-ranked deposits are repaid? Hybrids typically only rank above the ordinary shares of the issuer.
Why invest in hybrid securities?
There are many reasons investors may choose to invest in hybrid securities, including the potential to:
- Receive an income stream for a pre-determined period, although the certainty of cash flows varies depending upon the hybrid structure
- Improve the return on your capital
- Vary the risk profile of your overall portfolio
- Profit from anticipated movements in interest rates or equity prices
- Utilise the franking credits attached to distributions on hybrids
Risks of Hybrid Securities Investments
While margin lending gives the potential for investors to magnify their gains in a rising share market, any form of borrowing to invest risks the possibility of magnifying losses. When borrowing via a margin loan to invest in shares or managed funds, this risk is more significant due to the highly liquid nature of the investment.
A higher level of risk is associated with hybrid securities when compared to a regular bond, term deposit, or fixed interest investment. The conditions, timeframe, risks, and return of each hybrid security will differ, and some may have complex features.
- Complexity: While most hybrid securities are structurally similar, it is crucial to understand that each security contains complex features that may impact the security's value.
- Conversion: Under certain circumstances, issuers may convert hybrids to ordinary shares, which may sometimes see the investor receive less than their initial investment.
- Credit Risk: The risk that the issuer may default on its payment obligation. Higher credit risk requires a higher return to investors to compensate investors for the increased probability of expected losses. In most instances, distributions are discretionary, and the issuer can stop making distributions, which may not constitute a default event.
- Deferral of Distributions: Issuers, in most instances, reserve the right to defer or cease the payment of distributions on security. This can adversely impact the price of the security and expected income.
- Interest Rates: Hybrid securities typically pay a fixed margin above the bank bill swap rate (BBSW). If BBSW declines, this could reduce the expected income over time.
- Liquidity: Hybrid securities are typically less liquid than ordinary shares of the underlying issuer.
- Market Price Volatility: Like shares, the price of hybrid security will fluctuate in response to changes in market conditions.
- Subordination: Hybrids are unsecured credit, meaning they rank behind senior bondholders and other creditors in a wind-up scenario.
- Term Risk: The security may remain outstanding for a shorter or longer than expected. Issuers may be able to terminate the investment early but may not extend that same right to the investors. On the other hand, some hybrids may have investment terms lasting several decades and can withhold repayment until maturity if their financial position deteriorates.
The risk and potential return for Hybrid Securities is somewhere between common stocks and regular bonds.
