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Where the cash is going
This article appeared in the June 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
ASX-listed debt and hybrid markets setting volume records.
By James Ramsay, Bell Potter
Almost halfway into 2012 the signs are clear that investors with an interest in high-yield fixed income would do well to turn their attention toward events occurring on the ASX-listed debt and hybrid markets. (Editor's note: listed fixed interest products are becoming more popular with yield-seeking investors and Self-Managed Super Funds.)
Investors not closely following these markets may be unaware that records are being broken. In February this year subordinated debt issues by Tabcorp, ANZ, AGL, Colonial Group (a wholly owned subsidiary of CBA) and the convertible preference shares from Westpac meant 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 is a 20 per cent increase on the current $25-billion ASX-listed debt and hybrid markets.
There are two main reasons for the recent large issuance of this style of security.
- First, wholesale funding has become relatively expensive, so issuers are seeking to source the vast amounts of cash sitting under-utilised in bank cash accounts.
- Second, changes to the treatment of this style of debt by credit rating agencies makes it more attractive for companies to issue debt with an "equity credit" feature.
How investors can get access
Retail investors can purchase debt and hybrid issues through initial public offerings (IPOs) from the issuing company. This is known as the primary issue. Investors also have the option to purchase through 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 understand the structure of the instrument and its pricing, and also how it fits within an individual's portfolio.
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 affect the performance over the life of the security.
ASX-listed hybrids may form part of a fixed-income portfolio, depending on 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 because of their position in the capital structure of the company.
- Distributions paid may offer franking credits.
Advantages of ASX-listed hybrids
- 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.
- ASX listing provides liquidity, full company reporting and disclosures.
Risks of ASX-listed hybrids
The main risks associated with holding hybrid investments are:
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 (FRNs) in a rising interest rate environment.
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.
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.
Early redemption risk
The risk associated with early redemption that may be due to changes in interest rates, potential takeover, listing of the parent company, or default.
Fixed or floating-rate debt securities?
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 90-day bank bill swap rate.
If the bond market has less risk 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 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.
About the author
James Ramsay is a private client adviser with Bell Potter Securities Limited, one of Australia's largest independent stockbroking firms. It has an experienced team dealing with fixed income and is one of only a few Australian stockbrokers producing research and managing investments specific the asset class this article refers to.
Information provided is of a general nature, so consult an investment professional before making a decision.
For a copy of Bell Potter's Fixed Income in Australia - An Investor's Guide, contact James Ramsay.
To learn about the features, benefits and risks of listed fixed-interest products, do the ASX's free online interest-rate securities course.
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.
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© 2013 ASX Limited ABN 98 008 624 691