Investors not closely following the ASX debt and hybrid markets may be unaware that records are being broken. In February this year subordinated debt issues by Tabcorp, ANZ Bank, AGL, Colonial Group (a wholly owned subsidiary of CBA) and the convertible preference share by Westpac meant that the ASX listed debt and hybrid markets hit a monthly record for new raisings.
With some $5 billion raised for the year to date, this amount exceeds the total funds raised across 2010 and 2011 and represents a 20% increase on the current $25 billion ASX listed debt and hybrid market.
What’s driving these events?
There are two main reasons for the recent large issuance of this style of security. Firstly, wholesale funding has become relatively expensive – so issuers are seeking to source the vast amounts of cash that are simply sitting underutilised in bank cash accounts - and secondly changes to the treatment of this style of debt by credit rating agencies making it more attractive for companies to issue debt with an ‘equity credit’ feature.
How do investors access this section of the market?
Retail investors can purchase debt and hybrid issues through public offerings (IPO) from the issuing company – this is known as the primary issue. Investors also have the option to purchase through the ASX on the secondary market. Trading of listed bonds is identical to that of ordinary shares. Like shares, when purchasing debt and hybrids on the secondary market it is vital to ensure, not only, an understanding the structure of the instrument and its pricing, but how it fits within an individual’s portfolio.
Understanding hybrid securities
Hybrid securities are a complex capital instrument that combines characteristics of interest rate securities and equity capital. Hybrids may incorporate a more debt like bias or have more equity like features depending on the needs of the issuing company. These differing characteristics will have an impact on the performance of the instrument over the life of the security.
Hybrids that are listed on the ASX may form part of a fixed income portfolio depending upon the risk criteria of the investor. Every ASX listed hybrid has its own unique characteristics and the details are outlined in the original prospectus.
In most cases, a hybrid will rank above ordinary equity and provide a regular cash flow (like fixed income). However, unlike senior debt securities, the income from hybrid securities may be withdrawn or deferred at the issuer’s discretion and the hybrid instrument ranks below senior debt securities in the capital structure of the issuing company. Hybrids also contain equity characteristics by offering an option to convert the hybrid into an underlying equity when a particular event occurs (e.g. at maturity or following a change of control).
Key features of hybrids
- Hybrids pay a predetermined distribution (either fixed or floating) at regular intervals, so the investor has a known cash flow;
- At the conversion date, holders may have a number of options including converting the securities into the underlying ordinary shares of the issuer or receiving the repayment of the original capital at par value;
- Hybrid securities have a wide variety of maturities and structures across the risk spectrum allowing for diversification of term and risk;
- Hybrids generally offer higher returns than more senior securities due to their position in the capital structure of the company; and
- Distributions paid may offer franking credits.
- Offer a wide range of issuers, maturities and structures ensuring that investors are able to construct a diversified portfolio;
- Generally offer higher returns than senior debt of the issuing company reflecting the higher associated risks of the securities;
- Potential tax benefits through fully franked distributions;
- Opportunity to participate in the company through the share conversion option;
- Hybrids rank ahead of ordinary shareholders; and
- ASX listing provides liquidity, full company reporting and disclosures.
Risks of ASX listed Hybrids
The main risks associated with holding hybrid investments are:
Credit risk: The risk that the issuer may not be able to pay its obligations (distributions or capital) at the due date. Hybrid investors rank ahead of ordinary shareholders in the capital structure of the company. The higher the credit risk, the greater the required return. Investors need to assess their risk tolerance before purchasing any security including hybrids;
Interest rate risk: this is the risk to the market value of the securities due to changes to the interest rate cycle. A fixed rate interest security will typically appreciate in capital value if interest rates fall and depreciate in value in a rising interest rate environment. Investors may mitigate this risk by purchasing floating rate notes (FRN’s) in a rising interest rate environment;
Margin risk: All fixed income securities trade at a margin above “risk-free” assets (Commonwealth Government Bonds.) The margin received over the risk-free rate is dependent on many factors including general economic conditions, the balance sheet and solvency of the issuer. The higher the margin the greater the risk associated with the investment;
Liquidity risk: this is the risk that you will not be able to sell your bonds when you want at the price you want as there may not be sufficient buyers; and
Early redemption risk: This is the risk associated with early redemption that may be due to changes in interest rates, potential take-over, listing of the parent company or default.
Fixed or Floating Rate Debt Securities? Floating rates offer some protection from an upturn in the global economy
Bell Potter believes that investors who require income and are prepared to accept some risk should consider floating rate ASX listed debt or hybrid securities. The majority of debt and hybrid securities pay a distribution that offers a fixed margin over the floating BBSW90 rate.
If the bond market de-risks due to improved economic growth, stability and confidence, demand for high yielding assets will be strong. This demand will contract the risk margin or margin to swap, for floating rate listed debt and hybrid securities, and hence increase the price.
Bell Potter believes that investors should consider switching a component of their cash and fixed interest holdings from the so called low yielding “risk-free” securities such as Commonwealth Government bonds and long dated bank term deposits into a portfolio of high margin ASX listed floating rate debt and hybrid securities. Assuming the strong bond markets weakens, we believe these ASX listed debt and hybrid securities should increase in value.
For you copy of Bell Potter’s fixed income publication Fixed Income in Australia – An Investor’s Guide please contact James Ramsay – firstname.lastname@example.org.
By James Ramsay and the Fixed Income Team of Bell Potter Securities Limited
''James Ramsay is a Private Client Adviser with Bell Potter Securities Limited, one of Australia's largest independent stockbroking firms. Bell Potter provides a full range of services to institutional, corporate and private clients. We bring together a highly experienced team to accommodate our clients’ fixed income requirements. Bell Potter is one of the few Australian stockbrokers producing research and managing investments in this investment class.
James Ramsay is accredited to advise in Australian and International Equities, Level 1 & 2 Derivatives, Fixed Interest Securities, Listed and Unlisted Managed Investments and Government Bonds and Debentures. Information provided here is of a general nature please consult your own investment professional before making a decision.''