Myths about hybrids debunked

By Norman Derham, Elstree

There has been much negative commentary written about hybrids recently that does not depict the sector in general, because the commentators do not have an extensive enough database to make informed comments, choosing instead to cherry-pick particular securities as examples.

Elstree has an extensive database extending back to 1999, which enables us to make informed comments about the behaviour of the sector in aggregate, as well as on a security by security basis.

In broad terms we think many of the commentaries are plainly wrong and some of the others are predicated on hybrids being the income portfolio rather than part of the portfolio.

Below are the most common pronouncements:

"Hybrids display equity-like volatility" - This is simply not true.

That it is not true is clearly demonstrated in the chart below, which details the risk (volatility, horizontal axis) and return (vertical axis) "snail trail" on a rolling 12-month basis for the All Ordinaries Index (blue) and the Elstree Hybrid Index (red) from September 2008 (the first dot point is the rolling 12-month return to September 30, 2008) until November 2012 (the last dot point).

The worst outcome at the height of the GFC saw hybrid volatility (standard deviation, or risk) at around 50 per cent of equity market volatility while returns were around 30 per cent better on a rolling 12-month basis at the worst point.  In short, hybrids offered better returns and much lower volatility than shares during this period.

Risk return snail trail (All Ordinaries and Elstree Hybrid Index) chart

Source: Elstree Investment Management

"Hybrids behave like equities" - Untrue except during a catastrophic event such as the GFC.

The chart below displays rolling three-month returns of the Elstree Hybrid Index and the All Ordinaries Accumulation Index. Except for the immediate GFC period when hybrid and equity returns were highly correlated, hybrid and equity returns are largely uncorrelated (that is, they have a weaker relationship and are less likely to move in the same direction).

Since the GFC, rolling three-month equity market returns have fallen by more than 5 per cent on seven separate occasions. The average hybrid sector return during these negative equity return periods was +2 per cent.

All Ordinaries and Elstree Hybrid Index chart (3 month rolling returns)

Source: Elstree Investment Management

"Hybrids are not a defensive asset" - This is half true and depends upon the event circumstance.

The chart below shows the quarterly returns of the Elstree Hybrid Index (red) and the UBS Composite Bond Index (blue). As the chart shows, in a catastrophic event such as the GFC, hybrid security returns fell dramatically while fixed-rate bond returns rose.

There have, however, been other major event shocks such as the global bond meltdown of 1994, Long Term Capital Management (LTCM), the Russian debt crisis of 1998, and the Japanese lost decade experience where fixed-rate bonds did not perform as you would expect of a defensive asset.

In Japan, for example, Japanese Government Bonds underperformed bonds issued by corporate borrowers during much of the lost decade, when margins on corporate bonds contracted (prices rose) because of a combination of factors. These included excess liquidity provided by Japanese banks and the zero interest-rate policy of the Bank of Japan.

All maturities and Elstree Hybrid Index returns and correlations

Source: Elstree Investment Management

"Equity outperforms hybrids" - Untrue.

The chart below compares total returns of the ordinary equity and the hybrid of all dividend-paying hybrid issuers between September 30, 2009 and September 30, 2012. The returns include the benefit of franking for both the ordinary equity and the hybrid.

Hybrid/ordinary equity returns (30/09/2009 to 30/09/2012)

 
Source: Elstree Investment Management

The hybrid outperformed the parent equity in 13 out of the 18 companies over the three-year period, with the median outperformance of the hybrid being 6 per cent. We think the three-year timeframe is reasonable as it misses much of the immediate post-GFC bounces in both equity and hybrid markets and is representative of what we think economic and market conditions will be like over the next three to five years.

There was only one compelling equity outperformance and that was from Ramsay Health Care. Among the equities that did outperform, the margin of outperformance was not particularly large and equity investors were not getting compensated for the additional risk.

Even more interesting was the relative performance of the hybrids to the blue-chip equities such as Woolworths, Westpac, ANZ and Tabcorp. It is counterintuitive, but the share price of well-managed, profitable companies with positions of market strength (that is, the banks and Woolworths) can perform poorly if the share price is simply too expensive or if there is an excessive amount of earnings growth factored into the price.

In most cases, the hybrid outperformance was due to the poor performance of the underlying equity, of which the primary reason was that the equity was too highly priced to begin with. This is particularly important when we look at current bank share prices, which are pricing in either a higher return on equity (ROE) or growth in earnings.

"All hybrid behave the same" - Not true.

The average inter-security correlation (how closely they moved together) in 2011 was 0.17. This shows two things: first, that hybrid securities do not behave the same way all the time; second, that a diversified portfolio of securities is much less risky (because of the correlation benefit) than an undiversified portfolio.

"Cheaper similar securities offshore" - Partially true.

There are cheaper hybrids and similar securities offshore. But retail investors cannot access them easily nor can they hedge them (insure against a fall) appropriately. For institutional investors, there are other issues. Effective transaction costs are much higher and they are much more volatile. Our research shows returns from hybrids over any period in the past five years have been higher and about half as volatile, as comparable overseas credit markets (US corporate bonds, US leveraged loans, US high yield).

"Look at the poor price performance of some of the hybrids, such as Paperlinx, Elders" - True.

However, that's too narrow a universe. You could use the same analysis about OneSteel and never invest in shares again. Investors should only care about the performance of portfolios of securities, rather than individual ones, and hybrid portfolios should be well-diversified so the performance of those hybrids that perform poorly is offset by the high running (income) yield of the portfolio at large.

About the author

Norman Derham a principal of Elstree Investment Management Limited (Elstree), an executive-owned boutique manager specialising in the management of portfolios containing ASX-listed hybrid securities. The executives of Elstree have more than 80 years' combined experience in debt capital markets and have been managing portfolios of hybrid securities exclusively since 2003.

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