Hybrid way to higher yields

By James Ramsay, Bell Potter

With interest rates at record lows and cash rates slashed, the question everyone is asking is: how do I get a decent yield in this environment?

Traditionally investors would use a cash management trust or short-dated bank bills to achieve a higher yield than cash in the bank.

One alternative you may not be aware of is ASX hybrids. Before you start thinking about hybrid cars powered by a battery/fuel combination, let us define what a financial hybrid is.

As the name suggests, a hybrid is a combination of two or more different things, aimed at achieving a particular objective or goal. In this case it is normally equity and interest rate exposure combined together.

The hybrid market is an often overlooked sector of ASX but with recent issues from AMP and WBC it is worth revisiting. Hybrids can offer a combination of yield, capital growth and capital protection.

Assess the strength of issuer

Although it is a hybrid, you still need to assess the underlying strength of the issuer/parent company. Key operational developments for the issuing company will affect the level of risk attached to a hybrid's income and capital.

In terms of industrial companies, two key measures we look at for each company are net interest cover (EBIT/net interest) and gearing (net debt/shareholders' funds).

Depending on the industry, we ideally require a minimum interest cover of 3.5 times and gearing preferably below 50 per cent. Adverse movements in these metrics will ultimately increase the perceived level of risk, reduce the equivalent credit rating on the hybrid, and result in a decline in security price to adjust for the increased risk margin.

Hybrids can be difficult to understand, so get to know some common terms and definitions:

• Cumulative - Describes a preference share for which unpaid dividends accrue.
• Gross margin to swap - Gross running yield less the relevant swap rate.
• Gross running yield - Forecast dividends (or distributions) over the next 12 months divided by the current security price. Where the dividend is fully franked, the yield includes the grossed up amount of the franking credits.
• Gross yield to maturity (including conversion discount) - The annualised internal rate of return on the hybrid's cash flows, including purchase (current) price, forecast future dividends grossed up for franking credits, and the value of shares on conversion at maturity, which includes the conversion discount. Although this assumes all issues are converted into shares on maturity/reset date, this may not occur on some issues where the issuer has the option to apply a step-up margin.
• Non-cumulative - Describes a preference share for which unpaid dividends do not accrue.
• Swap rates - Bank Bill Swap Rate (BBSW) is the primary benchmark interest rate for the Australian money markets. BBSW is also used as a reference rate for floating rate hybrids. Dividend payment rates are set at a margin to the relevant BBSW for each dividend period. Quarterly dividends are based on 90-day BBSW, and half yearly dividends are based on 180-day BBSW. Fixed rate issues are typically priced at a margin to the Five Year Swap Rate at the time of a new issue or reset of terms.
• Floating or Fixed notes - How the interest is calculated. Floating notes normally use the BBSW plus a pre-determined margin. Fixed notes pay interest at a predetermined rate that does not move when the BBSW rate does.
• Credit rating - The credit rating of the underlying issuer or parent company.
• Conversion date - Date at which a conversion event takes place. There is normally one of three events that happen at the conversion date as detailed below in the conversion type.
• Conversion type - Normally one of three circumstances happens when conversion takes place. It is redeemed at face value, it is converted to shares in the underlying company, or it is stepped up with a new margin.

When looking at hybrids the devil is in the detail - a good understanding of each term and reading the product disclosure statement (PDS) is a wise move. The PDS will detail any events that can create a change in the conversion method. To get the most from hybrids you must know what happens at maturity.

About the author

James Ramsay is a personal investment advisor at Bell Potter Securities. Bell's hybrid weekly report, available to clients, lists 25 fixed and floating rate hybrids with a risk rating on each.

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