Hybrid securities are popular with many investors but it is also true to say than many don’t like them. This probably leads to some confusion and possibly some misinformation about the risks of hybrids and how they are ‘supposed’ to perform as investments.
The terms contained in the hybrid issuing documents detail a range of circumstances about how hybrid capital will be used in the event of a company approaching a default scenario. It’s probably true to say that most investors don’t read the Product Disclosure Statements to fully understand those risks, relying instead on the advice of stockbrokers – who are well-remunerated to sell hybrids – and the reputation and standing of the issuing companies. This can create some investor angst when hybrid security prices become volatile as prices can become dislocated very quickly from what is considered ‘normal’. In non-volatile times hybrids can provide a higher-than-term-deposit return to yield hungry investors. When markets become volatile, as they have done in the first 6 weeks of 2016, then securities prices can lead to investors questioning their investments performance.
Norm Derham, from Elstree Investment Management, runs a hybrid securities fund. In his monthly missive to clients in January he tackled the topic of volatility in hybrid security pricing saying, “We are constantly bemused by comments about the correlation that exists between the equity and hybrid markets. In the absence of a default event hybrids issued by investment grade issuers should behave like corporate bonds issued by an investment grade issuer. So over the long term, in the absence of defaults, it would be reasonable to expect the correlation would be low. And it is.”
However, in the short term as the markets ebb and flow and investors react to market noise and the volatility of equities the correlation to equity markets is higher.