So-called hybrid investment products have been in the news recently as a number of local financial institutions have issued some of the Basel III compliant products, at margins over the 90 day bill rate.
These products are largely targeted at mums and dads, and self-managed-super funds. Investors who, regardless of the ASIC denomination of retail or sophisticated investors, are unlikely to understand the important nuances of the risks associated with buying hybrid bonds. Instead they are focussed on the return over term deposits of other financial institutions bonds.
It highlights the different psychological profiles of bond and equity or stock investors, in that bond investors are interested in the return OF their money whereas stock investors are focussed on the return ON their money.
Indeed it is often the case that financial crises, like the GFC or the implosion of hedge fund LTCM in the late 1990s, are a direct result of bond investors forgetting about the return of their money and only focussing on the return on their money that led to these events.
As the robot from Lost in Space would say: “Danger Will Robinson”.
It’s a theme picked up by JB Were’s fixed income investment team in a recent note to clients on “Positioning Hybrids in Portfolios”. It’s clear from some of the phrases in the note that the team feels the need to underline the risk levels associated with the products.
JBW says their fixed income research and investors’ portfolio allocation should be focussed on “capital preservation and a level of return that compensates investors for the risk. Capital preservation not only includes an appropriate return on capital and return of capital at maturity, but also the retention of capital value throughout the life of the instrument.”
Hybrid bonds don’t fit this bill and “are not the same as bonds or term deposits” because:
by virtue of their structure and nature do not adequately meet these criteria. They are prone to capital volatility in times of market disruption. Furthermore, in a scenario where an issuer is facing financial distress, there remains the potential for non-payment of coupons and depressed capital values or worse, the potential conversion to lower ranking equity and or permanent loss of capital.
Hybrids, particularly Basel III compliant bank and insurance hybrids, are mandated by APRA to be “loss absorbing”. More specifically, a hybrid’s role, as stipulated in their terms is to protect senior creditors of the issuer by providing a loss-absorbing buffer. This is not the type of security investors should rely on to maintain value under a distressed scenario. In short, a portfolio comprising of only hybrids should never be used to represent an investor’s defensive assets.
The interest in this somewhat arcane topic, is that hybrids appear recently clearly targeted at fixed income investors looking at the name of the issuer – usually a well known local financial institution – rather than the risk of loss on what is a loan (packaged as a bond) to these same institutions.
The benefits to the institution issuing the bonds are clear in the capital structure. It’s equity-like risk, with a bond-type cost. It’s a no-brainer for the issuing institution.
The following graphic offers another way of looking at it. If Government bonds represent risk-free investments, and equity the opposite end of the spectrum, then hybrids sit clearly towards the equity end of that spectrum.
Now no-one is saying that an Australian financial institution is about to go under and need resolution but as JBW says:
To be clear, hybrids do not represent defensive fixed income instruments and do not possess the capital preservation attributes sought from such instruments. Moreover, unlike traditional fixed interest exposures such as government bonds, hybrids are not expected to provide uncorrelated returns vis-à-vis equities in times of market disruption.
We have all been warned.