What is a Hybrid Security?
With relatively few hybrid securities listed on the ASX an investor could be forgiven for not knowing what one is. People will naturally avoid things they don’t understand which can sometimes mean missing out on a good opportunity. In the case of hybrids, they are not difficult to understand once some of the key features are outlined. The Rivkin Income portfolio almost exclusively holds hybrid securities and is a great way to obtain a good return for relatively low risk. Here we will explain in simple terms the mechanics of a hybrid security.
In order to fully understand hybrids we must first clarify exactly what debt and equity are. Equity ownership represents a claim on the net assets of a company, i.e. assets after subtracting liabilities. Retail investors can buy equity ownership in public companies by signing up with a broker and buying shares in the company. Equity owners have virtually unlimited upside if the company does well but can equally lose their entire investment if the company goes bankrupt. Other than potential capital gain, equity owners also have the potential to share in the profits of the business through the paying of dividends. Dividends are a voluntary payment by the company at the discretion of management and therefore not all companies pay dividends. In terms of relative risk, equity investments are at the high end. Shareholders are the last group to get paid in the event of bankruptcy.
At the other end of the risk spectrum is a debt investment. Bonds can be quite a complicated topic and there are endless possibilities for how a bond can be structured. Here we will explain the features of the most common type of bond. Fundamentally, buying company bonds is equivalent to loaning money to the company. The bonds will typically pay a fixed coupon on a regular basis (usually semi-annually) and will have a fixed maturity date. The face value of the bond is set at the time of issue and is the amount that you receive when the bond matures. This means that on the maturity date you will receive the final coupon payment plus the face value of the bond. The value at which a bond trades in the market can be different from the face value. If you buy a bond at less than the face value you are buying it at a discount and if you buy it for more than face value you are buying at a premium. Buying a bond at a discount will mean that the effective interest rate you receive will be higher than the stated interest rate and vice versa when buying at a premium. Debt is considered lower risk than equity because debtholders are the first group to be repaid in the event of bankruptcy i.e. all debtholders must be paid in full before shareholders can receive anything (in theory at least, courts can sometimes overrule this priority of payments). Furthermore, coupon payments on debt are mandatory, unlike dividend payments on stock which are voluntary.
Now that both debt and equity have been explained, we can look at what a hybrid security is. Essentially, a hybrid security has features of both debt and equity. Similar to debt, a hybrid security has a par or face value that will be repaid upon redemption. It also has a regular coupon payment although the amount of the coupon is usually variable based on the level of a certain benchmark, (e.g. the Bank Bill Swap rate) and includes a margin above the benchmark. This implies that if interest rates rise, holders of hybrid securities will benefit from an increased coupon payment, although obviously the reverse applies in the case of falling rates. Hybrid securities can have a fixed redemption date (like debt) but can also be perpetual. As the name implies, a perpetual hybrid means that you will continue to receive coupon payments forever (with a few caveats) but will never be paid back your principal. In reality, a perpetual offering will usually give the company the option to redeem the securities at their discretion and so it is likely that the hybrids will be repaid at some point, although the investor won’t know when that will be.
As with equity ownership, coupon payments on hybrid securities are voluntary, although generally speaking they take higher priority than dividends on equity. This means that the company can choose not to pay the hybrid dividend but it cannot then pay any dividends on common equity. The terms cumulative or non-cumulative will often be seen associated with a hybrid security. In the case of a cumulative dividend, if the company stops paying a dividend for a period it is obliged to make up the lost payments when it restarts paying dividends again. On the other hand, for a non-cumulative offer, the missed dividend payments are not made up.
Overall, hybrid securities are probably closer to debt than to equity. Generally speaking they do not benefit directly from the success of a company. They simply require the company to make enough money to cover the dividend payments and the eventual repayment of the par value. As they are ASX traded, they are an easy and convenient way to get a high rate of return for relatively low risk. At the time of writing, the official interest rate in Australia is 1.75% however there are hybrid securities currently offering yields north of 8%. Anyone interested in investing in Hybrid securities should contact Rivkin and ask about our income strategy.