What’s a hybrid security?

Hybrid securities are quite a common way for Australian retail investors to invest in a fixed income style investment. They offer a high coupon that are usually tax efficint. Retail hybrids are also often listed, so you have liquidity. But what exactly is a hybrid and why does it pay a coupon higher than you’d receive on a term deposit or other bond? Or, to put it more bluntly, do you know what you’re buying?

This post explains the basics.

So, what’s a hybrid?

Hybrid’s are fixed income instruments issued by financial institutions such as banks and insurance companies. These institutions are required to hold a certain amount of capital to cover the business they undertake. The more loans financial institutions make or the more insurance policies they write, the more capital they have to hold. Hybrid securities are a type of security that count towards this capital.

The “trick” with these securities and the reason that they count as capital, is if the company makes a large loss, the regulator (e.g. APRA) can enforce mandatory conversion the securities into shares if they believe the company is no longer viable.

Huh? What’s that mean? In English please.

Basically, if APRA (the bank and insurance company regulator) decide that the financial institution has lost so much money that it can’t continue to operate, then it will force conversion of the debt instruments into a number of shares. The idea is to protect depositors and policy holders and to ensure they get paid. Its the capital providers (the equity and hybrid security providers) that take the loss.

The good news is that on conversion you get shares in the company, which have some value. The bad news is that companies don’t issue an unlimited number of shares. They are capped. So you won’t get all your money back.

For example, say you own a bond with a value of $100 that is converted into equity. If shares are worth $2 each, you receive 50 shares. Easy maths. If the shares are worth 2 cents each, you receive 5,000 shares.

However, if the number of shares that can be issued is capped at 1,000, you won’t receive any more than 1,000 shares. At 2 cents each, this makes your shares worth $20, a loss of $80!

Ouch

The thing is, if conversion happens then the shares you receive are probably going to be nearly worthless. So, you would have done you dough.

This is the risk of owning a hybrid security

There is one final difference.

Some securities are not converted into equity but are written off. That means if the regulator decides to convert the bonds, you get nothing in return. Not even a worthless share. It pays to read and understand the PDS of the security you’re buying.

Is that why they pay higher interest than normal bonds?

Yep.

You receive an additional amount of interest to cover you for the risk that the bonds will be converted into equity.

Surely the government won’t let banks go bust!?

Welllllll, maybe. They probably won’t let the bank go completely under. Retail depositors will be saved and the bank will probably be merged with another Australian entity. However, that is what the capital providers are there for. The equity holders will be wiped out first and, if necessary, the hybrid security holders will be wiped out next.

Does that make them a bad investment?

No, not necessarily. Its all about understanding the risks of what you’re buying and deciding if the return compensates you for that risk. When you buy a hybrid security, you have to look past the high yielding coupon and franking credits and also consider the downside. What’s the chance of the bank or insurance company getting into financial difficulty? If it does, will I lose my money?

What you are effectively buying is a fixed income security that ranks just about equity and will, if the underlying company runs into financial trouble, will be converted by the regulator.

So, why do I get franking credits?

Just to complicate matters a little bit more, for tax purposes hybrid securities are treated as “equity” and not debt. Ignoring the rest of the complexity around that, just know that often your returns include franking credits.

Anything else I should know?

One more level of complexity.

Hybrid securities are typically classified into either Tier 1 or Tier 2. While they may look broadly the same, there is a subtle but very important difference between them that basically boils down to Tier 1 being converted before Tier 2.

Most retail offerings are Tier 1.

Phew that’s a lot to take in – can you show me an example?

That’s a good idea. Let’s look at a recently issued Macquarie Bank hybrid. I’ve summarised the key terms from section 1 of the prospectus (which you should read!), with an explanation of each.

TermExplanation
Fully PaidYou pay $100 upfront for a $100 bond.
SubordinatedIf the company goes bust, you get paid after the depositors and senior debt holders, but before the share holders.
Non-CumulativeIf they don't pay a distribution for some reason, then you don't get a catch up payment next time.
UnsecuredYou have no rights over the assets of the company
Mandatory conversionThe bonds will convert to shares in 2029.
Automatic conversionThat's the non-viability clause
PerpetualUnlike most bonds, these have no end date. In theory they could be round forever. You get your money back either by selling on market, or if Macquarie redeems them (i.e. buys them back).
CouponYou get paid 4.15% plus BBSW adjusted downwards for franking credits. As BBSW is a floating rate (i.e. it moves around), the coupon you receive will go up or down depending on the rate.
Where you rank as a note holders.

Hope this provided a short introduction to hybrid securities. Feel free to ask questions below.

James Scott

James Scott is a personal finance expert with over 20 years experience. He believe that money should not be stressful. By using the Stress Free Money pyramid it helps everyone achieve their financial dreams.

You may also like...

1 Response

  1. July 1, 2019

    […] only getting a return at the end if there is anything left. Some special types of bonds like hybrid securities have qualities of both fixed income and […]

Leave a Reply

Your email address will not be published. Required fields are marked *