Why include hybrid securities in an investment portfolio?

Shaw and Partners
Steve Anagnos
Steve Anagnos
Shaw Co-Head, Income Strategies
2
Over the last 20 years the question we are asked is are hybrids equity or debt securities. The answer is neither.

Although they have features and characteristics of both ordinary equities (shares) and debt (bonds) they are actually their own asset class.  

They have a very different short term and long term risk and return profile to other asset classes.  

Treating hybrids as their own asset class and therefore their own allocation to an income (or growth) portfolio, as opposed to trying to fit into either of the traditional asset class allows investors the ability to take advantage of the opportunities the asset class offers.  It’s all about diversifying the risk of temporary or permanent loss (or drawdown) to the capital value of the portfolio whilst seeking an income return.

Hybrid securities generally provide higher yields than debt to compensate for the higher investment risk. Hybrid securities pay a regular fixed or floating rate of return or dividend (including franking credits) until a certain date. In this regard, holders are paid interest or a dividend for holding the security for a predetermined period. 

At maturity or on a reset date, the issuer may have the right to decide one of the following options:

convert the hybrid securities into the underlying equity of the issuer;
redeem the hybrid securities, usually at face value; or
roll into another hybrid structure or even a combination of the above.

Hybrids can take the form of Converting Preference Shares, Step-up Securities, Convertible Notes and Perpetual Income Securities. Each has different risk and reward characteristics, and by blending security types, issuer quality, maturities, as well as securities trading at a premium/discount to face value, a number of bespoke outcomes can be created to offset ordinary equity risk in a portfolio, whilst generating sustainable and predictable returns.

Investors often focus on yield maximisation as their main investment objective. As a result, many investment portfolios hold a substantial allocation to high dividend equities. Such a narrow focus without consideration of encompassing the full universe of available and suitable investments may potentially result in an unexpected and permanent drawdown. It’s interesting that over the last 12 months the holding period returns have been higher in a portfolio of major bank hybrids as compares to holding the underlying shares.

By understanding the dynamics and relative returns and risks of the complete capital structure (debt and hybrids), and appropriately allocating to this sector, as well as individual securities, investors with clearly identifiable investment objectives are able to maximise the likelihood of achieving these objectives. 

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Must admit, I'm a novice when it comes to hybrids. Looking forward to learning more from the guys at Shaws

Thanks, this was interesting

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