Hybrid securities - a useful investment
Hybrids are complex instruments that vary in their features, but can offer attractive returns.
Clients with an allocation to Income Securities hold several hybrid securities in their portfolio.
What are Hybrids?
Hybrids provide an alternative way for companies to finance themselves. They exist somewhere between debt and equity (shares) – and typically have features of both.
This means they typically deliver a higher rate of return than regular debt securities, but typically have a lower return than shares.
Issuers of hybrid securities in Australia are typically large companies – banks, insurance companies and well-known corporates.
How do hybrids differ from debt? They can vary significantly when it comes to their features.
Some jargon that is used to describe these features includes convertible/nonconvertible, cumulative/noncumulative, perpetual, callable/non-callable, fix or floating.
You would not be blamed for thinking that this sounds complex, it can be, but that is part of their attraction.
Why own hybrids?
The first reason is that the hybrid market is relatively small and unsophisticated.
Approximately 70% of new issues are purchased by small shareholders and the secondary market for these securities is overwhelmingly dominated by retail investors.
This makes for an unusual pairing: retail investors must value complex instruments, with a range of features and embedded options. The result is opportunities to purchase mispriced securities. First Samuel’s size means we are nimble enough to take advantage of this.
The second is that, in general, hybrids provide a higher return than typical debt instruments.
This is in exchange for some features described above – which often give greater flexibility to the borrower. This can lead them to have more “equity-like” characteristics and in periods of stress, hybrids can behave more like equity than debt.
However, they can also provide features that benefit the lender (investor) such as the ability to utilise franking credits. Furthermore, hybrids have been relatively resilient in past market sell-offs – declining by significantly less than the market.
One way we achieve a broad exposure to hybrid investments in your portfolio is through the Australian Enhanced Income Fund (AYF.ASX). The fund provides a way to diversify between highly technical preference shares, and benefits from the Elstree Investment’s (the investment manager) extensive experience in research and trading in this market. This expertise has been reflected in their recent performance - in April, the fund outperformed the broader hybrid index by more than 2.5%.
How have hybrid securities performed recently?
Hybrid securities have provided a good source of income in your Income Securities portfolio over the past few years, having returned an average of approximately 5% p.a. since 2017.
However, given that hybrids have features of both debt and equity, it is not surprising that they, too, were impacted by the recent coronavirus sell-off.
Yet, as we expected, the broader hybrid market declined significantly less than the equity market – approximately 30% less.
It has recovered strongly since.
The reason for this is at their lows, hybrids were offering considerable yields. The hybrid market has historically had strong support from buyers at yields between 4.00-5.00% + BBSW (an interest rate benchmark that varies) . At these prices, the hybrid market has historically returned approximately 7-10% over the next 12 months - an attractive return that is in line with that of equities.
Investors searching for yield have therefore provided strong support, with the broader hybrid market now yielding less than 4%.
As a result, your securities have recovered well, with the majority currently trading within 5% of their February highs (to Thursday).
Their position in your portfolio
A number of your hybrid securities continue to present value.
However, some securities have become more fully valued. As investors have bid the price of these securities up, we have been lightening your exposure.
In general, we continue to see hybrids as a good source of income in the portfolio.
The structure of the hybrid market means that there will likely be opportunities for further investment in the future. However, hybrids are only part of your Income Securities sub-portfolio.
We continue to evaluate new opportunities within the debt market and are willing to sell as better risk-adjusted opportunities present in the future.