By guest contributor Elaine Li, analyst, Atchison Consultants
We have recently seen some robust discussions by commentators and investors in response to ASIC Chairman Greg Medcraft’s view about hybrids and their suitability for Australian retail investors. Mr Medcraft was quoted as saying that hybrid securities were a “ridiculous” product for retail investors. We think given these comments it would be an opportune time to have a closer look at hybrid securities in the context of their suitability as an investment proposition for retail investors.
The basics
Hybrid securities are financial instruments which feature both debt and equity characteristics. These characteristics impact the performance of the hybrid securities, with a significantly higher volatility of returns compared to what standard “vanilla” unsecured debt investments typically provide. This volatility reflects the greater credit risk taken on as well as the volatility from the equity exposure and listing on the stock exchange. (Many Australian hybrids, but not all, are listed on the ASX. Some are issued in offshore markets.)
Under Basel III rules, capital used by authorised deposit-taking institutions may include the following sources which are ranked in order of security of capital.
- Deposits
- Retail
- Wholesale
- Senior Debt
- Senior secured/covered bonds
- Asset-backed securities
- Senior unsecured
- Tier 2 Capital
- Subordinated debt
- Hybrid
- Tier 1 Capital
- Tier 1 compliant hybrid capital (i.e. subordinated contingent perpetual/”CoCos”)
- Equity capital (common equity tier 1)
Hybrid securities can be thought of as consisting of two components:
- a fixed income component and
- an equity component
Consequently, returns and risks of hybrid securities resemble a combination of returns and risks of fixed income and equities.
Within a company’s capital structure, hybrid securities are ranked lower than debt securities, which indicates hybrid securities will carry a higher level of credit risk. Being part-equity, hybrids’ returns are expected to exhibit greater volatility. In other words, returns on hybrid investments will vary more from year to year.