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Attractive yield without the volatility

Photo of Norman Derham By Norman Derham

min read

Why hybrids are a useful asset in most portfolios as a risk-mitigating tool.

Contrary to much commentary over the past few years, hybrids do not produce bond-like returns with equity risk, just as they do not provide much of the equity downside with little of the equity upside.

The experience of the past 15 years tells us that hybrids are in fact less volatile than equities, do not always move in the same direction as equities, and experience much less drawdown than equities during a drawdown event such as the GFC.

The chart below shows the All Ordinaries Accumulation Index and the Elstree Hybrid Index return outcomes since January 2006, which includes the 2008-09 Global Financial Crisis. Note that hybrids and equities have produced a similar return outcome over the period, but hybrids have achieved it with about a third of the volatility.

Source: Elstree and ASX

Because hybrids are less volatile and display a low correlation (relationship) to equities, they are an ideal inclusion in almost any portfolio as a risk-mitigating tool.

(Editor's note: 'Hybrid security' is a generic term used to describe a security that combines elements of debt securities and equity securities. Hybrid securities typically promise to pay a rate of return, fixed or floating, until a certain date, in the same way debt securities do. However, ASX-listed hybrids also have equity-like features that can mean they may provide a higher rate of return than regular debt securities. To learn about the features, benefits and risks of ASX-listed hybrids, take the free ASX Bonds and hybrids online course.)

Reasons to include hybrids in portfolios
Of course, the inclusion of an asset just because it reduces risk is not sufficient reason for it to be in a portfolio. The asset must also make sense as a standalone investment.

At current yields and spread margins (yield and spread margin move in the opposite direction to price: an increase in yield and margins will result in a fall in prices) we believe hybrids represent such an investment.

As an example, the recently issued CBA PERLS VIII offers investors a spread margin over the bank bill swap rate of 5.20 per cent – the equivalent of a 7.5 per cent yield. This 5.20 per cent represents a record margin over the bank bill swap rate for a new-issue major Australian bank Tier 1 bank capital instrument.

It is worth noting that at the GFC’s nadir  in February 2009, spread margins on Tier 1 bank capital instruments traded as high as 5.99 per cent over the bank bill swap rate. This means spread margins are now approaching a level last seen at the worst point of the crisis of 2008 and 2009. 

This begs the question,  why are spread margins at these levels and does the margin of 5.20 per cent over the bank bill swap rate represent sufficient compensation for the sum of the risks to justify investing in Tier 1 bank hybrids?

Why spread margins are at these levels
Because the hybrid market is small (capitalised at $46 billion) and populated almost exclusively by retail investors, it is vulnerable to supply imbalances and mispricing. This means the market (or indeed individual securities) may take some time to revert to fair value.

In the two years to the end of September 2015, around $12.5 billion of major Australian bank Tier 1 capital instruments were issued. This initial public offering (IPO), or primary market supply, resulted in a digestion problem for a market typically used to absorbing around $3 billion a year.

The jumbo-size $3-billion CBA PERLS VII issued in August 2014 set the scene for spread margins to widen (prices to fall) dramatically, from which the market is yet to fully recover. A spate of subsequent primary market hybrid security offerings from the other major banks ensured that spread margins and prices have remained under pressure since.

Secondary market supply was also a contributing factor throughout much of this period as investors sold down hybrids to fund new bank equity capital raisings. While weaker and more volatile equity markets have impacted negatively recently, because of the low equity beta the impact has not been material.

What drove the supply
Supply from both primary and secondary market sources is the direct result of the banks bolstering their equity and hybrid capital stocks at the insistence of the Australian Prudential Regulation Authority (APRA) under the direction of the global banking regulator.

While it is widely held that APRA is still on a path of higher capital ratios for the banks, we are not expecting much “new” hybrid supply this year, as we believe the banks broadly have sufficient hybrid capital to satisfy their Tier 1 hybrid/equity capital ratio requirements. Any increase in Tier 1 capital in the future will come from increased common equity.

What we will see, however, this year and next, is the banks rolling their existing stock of hybrid capital into “new” Basel 3-compliant instruments. We have just witnessed such an event with the CBA PERLS VIII replacing the CBA PERLS III.

Does the current spread margin compensate investors for risks?
To put the current spread margin of 5.20 per cent in perspective, it is worth remembering that before the GFC the CBA PERLS III listed at a spread margin of 1.05 per cent over the bank bill swap rate.

While the banking system is more volatile than previously thought and the capital instruments issued post-GFC now include equity conversion risk (being a product of the banks’ adherence to Basel 3), the increase in spread margins post-GFC has been material at nearly five times what it was before the GFC.

What investors have to ask about the PERLS VIII today is, does the margin of 5.20 per cent over the bank bill swap rate represent sufficient compensation for the sum of all the risks, which include default, liquidity, extension and equity conversion risk?

Different nuances
From the retail investor’s perspective, hybrids are complex. While they may be similar, no two security structures or issuers are the same. All have different nuances and behave in a random way, which results in different price behaviour.

Owning three or four securities can be risky, as one or two of those might all  perform poorly at the same time. While it is not practical to own all 65 securities in the Hybrid Index, the random behaviour of securities dictates that owning more, rather than less, is definitely the preferred option.

An investment in hybrids is best served by buying 25 to 30 securities and not trading them, or outsourcing the management to a specialist hybrid manager who understands the security structures, can construct a diversified portfolio and can capitalise on the market’s many periodic inefficiencies.

About the author

Norman Derham is a founding director of Elstree Investment Management, a specialist hybrid fund manager. Elstree has been managing portfolios of hybrid securities since 2003 and the executive directors have more than 90 years’ combined experience in debt capital markets.

From ASX

The free ASX guide, 'Understanding Hybrid Securities' has more detailed information on the features, benefits and risks of hybrids, and how they compare to other types of securities.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2015 ASX Limited ABN 98 008 624 691. All rights reserved 2015.
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