SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
Hybrid Securities Part 1 – what are they and what are the risks?
Many thanks to Dean Greacen from SMSF Investor for today’s post. Dean will be sharing with us a series of posts on Hybrid Securities, which could be a great investment for SMSFs seeking high yield with capital growth.
Hybrid securities have the characteristics of both debt and equity and the enormous growth of hybrid securities in today’s marketplace can be best explained by financial markets seeking financial instruments of varying risk and reward. What makes hybrid securities so attractive to investors are the numerous combinations of payments, rights and obligations available in the hybrid marketplace.
Hybrids provide investors with a predictable dividend or interest payment at a benchmark rate of return called the Bank Bill Swap Rate (BBSW) plus a margin that reflects the credit risk of the issuer. The yield on hybrid securities is nearly always greater than the standard yield offered by direct equity securities and makes hybrid securities more attractive than shares as an income producing asset. Hybrid securities are not, as a general rule, growth assets like shares, but can offer equity upside (capital growth) that may give rise to capital gains depending on the performance of the underlying ordinary shares of the issuer. The convertible nature of some hybrid securities also offers investors a form of indirect access to the ordinary share equity of the issuer.
Examples of hybrid instruments include Convertible Notes and certain Preference Shares. Convertible notes are a type of interest paying debt security that convert to ordinary shares (equity) in the issuing entity on maturity. Convertible preference shares and redeemable preference shares are an example of a hybrid security that may be considered by the ASX as equity when first issued, but offer investors dividends that resemble interest or coupon payments and therefore resemble debt securities. Each of these instruments will be covered in more detail in further posts.
How Do You Access Hybrid Securities?
Large companies, including financial institutions, life insurers and general insurers are the dominant issuers of hybrid securities. When hybrid securities are offered to investors for the first time, it is usually through a float or what is called an Initial Public Offering (IPO). This process occurs on the primary market with the entity issuing a prospectus to potential investors.
Organisations using hybrid securities to raise capital typically engage stockbroking firms to promote a float and distribute the prospectus to potential investors. If you wish to buy hybrid securities in a float you should first review their prospectus, then fill out the attached application form specifying the number of securities you wish to buy and send it with your payment to the issuing entity, or lodge it with a participating broker, before the application deadline.
The price of a hybrid security issued in a float is specified in the prospectus and is usually $100. The benefit to Investors who purchase hybrid securities in an IPO is that they do not incur brokerage costs, making IPO’s a great way to access hybrids at low cost.
Once issued in the primary market, hybrid securities then trade on the ASX (the secondary market) and depending on supply and demand factors and the credit quality of the issuer, trading can be either highly liquid or extremely illiquid.
What are the risks?
Most investors see hybrid securities as high yielding defensive assets for their portfolio’s and therefore a flight to safety during difficult times. However, the higher the yield on a security of this nature the higher the risks attached to it, which means the more likely they are to expose investors to price volatility during times of tight credit and liquidity markets.
The two main risks to investors in hybrid securities are credit or default risk, and term risk.
Default risk is the risk that the issuing entity defaults on payment of dividends or interest or repayment of your initial investment capital held with them and you don’t get your money back. Default risk represents a hidden danger, particularly in times of easy credit, strong risk appetites and plentiful liquidity because it won’t necessarily show up in price volatility. The key, therefore, to managing default risk appropriately is to only invest in the highest credit quality hybrid securities available in the marketplace. Although hybrids represent a less risky investment than direct shares, the price of a hybrid security can also be affected by the performance of the issuing entity and may expose an investor to downside price risk. However, if an investor is dissatisfied with the performance of the issuer, they always have the option of selling their hybrid securities on the ASX any time prior to redemption or conversion.
Term risk involves the risk of investing in hybrid securities over long periods of time. Historically, longer maturity instruments have higher risks attached to them without the commensurate increase in expected returns. As such, the return from longer term hybrid securities is generally not worth the added risk. To avoid the price volatility attached to longer term hybrid securities the key is to stay relatively short term (i.e. no longer than 4-5 years). The best risk adjusted returns can be delivered by investing in short dated hybrid securities of 2-3 years.
A further but less important risk to investors of hybrid securities is liquidity risk. This is the risk that some investors may not be able to buy in or sell out of a particular hybrid security in a hurry at the price they want. Liquidity risk is, however, not a huge issue for the majority long term investors in hybrid securities because most investors purchase hybrids to access a constant and predictable income stream usually for the duration of their term (i.e. until conversion or redemption).
Why should SMSF trustees consider investing in hybrid securities?
Hybrid securities are suitable for SMSF trustees to include inside their investment portfolios both during the pre-retirement accumulation or savings phase, as well as the post-retirement pension phase when self funded retirees will be drawing on their superannuation life savings.
The decision to include hybrids in a SMSF portfolio and to what extent is therefore dependant on a person’s stage in life, time frame for investment and risk profile. Obviously there will be greater need for high yielding income producing securities during the pension phase in order to pay for a retirement income stream than during the accumulation phase of saving for retirement when growth assets are more important. The asset allocation process both pre and post retirement therefore becomes paramount as SMSF investors rebalance their portfolios to suit market conditions and their own personal situation.
For SMSF trustees who are not yet fully invested, hybrid securities are attractive financial instruments to invest in because of the appealing combinations they come in. For SMSF trustees who are fully invested, but want to include hybrids in their portfolio, the only way to do this would be to sell down some growth assets (i.e. shares) or use excess cash reserves.
Moving from pre-retirement to post-retirement will also necessitate the rebalancing process but it is important that SMSF investors get professional advice to ensure that the timing is right to avoid any unforeseen taxation implications as a result of this rebalancing.
____________________________________________________
SMSF Investor is a company that provides expert help to SMSFs. They offer SMSF clients a range of products and services tailored specifically to meet their needs as self managed super fund investors such as a SMSF Investor course and investment advice if needed.
Print This Post
