Income boosters

By Michael Saba, Evans and Partners

The rebound in credit and equity markets in 2009 has resulted in strong buying in hybrid securities. However, hybrid securities were not immune from the global financial crisis. As most current hybrids are interest-rate based, their pricing was greatly affected by the large increases demanded for corporate spreads.

In addition, because hybrids represent another form of company equity and attract a large amount of interest from investors on Australian Securities Exchange, the poor equity markets also had a great impact on pricing. Although the credit and equity markets are now recovering, buyers from a range of investor groups are scanning the hybrids sector for opportunities.

Comparative performance

The current more favourable conditions and rebound in pricing are shown by the performance of our Australian Hybrid Index. As shown in the chart below, the index has returned 14.67 per cent to August 20 compared with the S&P/ASX All Ordinaries Accumulation index performance of 23.5 per cent.

Despite this similar performance, the daily correlation of the hybrid index with the equity market is 0.30. A similar low correlation is found when comparing with bond market indices. The chart also shows that the volatility of the hybrid index compared with the All Ordinaries Accumulation index is well below that of the equity market in 2009.

The volatility of the hybrid index is only 6.4 per cent, whereas the equity market is around 22 per cent. Also, since March 2009 the hybrid index has steadily risen despite some periods when the equity market has retreated, such as in early July. This reflects the regained confidence of hybrid investors.

80% rated investment grade

Hybrids are a diverse group of different security types from a range of companies, and this enables a breakdown of the hybrid index performance into sub-categories. In particular, it is worth examining performance according to the credit rating of the company.

The sub-index of hybrids rated as investment grade, which comprises about 80 per cent of the sector, has returned 10.3 per cent year-to-date, whereas unrated hybrids have rebounded strongly at 34 per cent. This performance reflects the oversold nature of the hybrid market in early 2009.

Subsequently, the price of many hybrids has been closely correlated to the ordinary shares of the issuing companies. In this category, hybrids from companies such as Fairfax, Goodman Group, Australand, Sky City, Elders and Nufarm have performed strongly as markets and the underlying equity prices have recovered.

In the rated sub-sector, the banks represent 60 per cent of the market, with the most popular structure being the recently issued mandatory converting preference share by ANZ, CBA, Macquarie Group and Westpac.

Hybrids from rated industrial companies include Orica, Santos, Tabcorp, Woolworths, Macquarie Airports and Insurance Australia. These have all performed well in 2009. Average margins for the rated sub-sector have contracted from about 8 per cent to 3.5 per cent (including franking).

Switch in weighting

Investors in general are looking to increase weighting exposure to interest-rate securities, divesting away from pure equity exposure. This is occurring in two ways: first, as part of their exposure to a company, a proportion of the weighting is being allocated to hybrids rather than fully in ordinary shares; second, on a standalone basis, hybrids are being used by investors to gain the more stable interest-rate return profile, especially in hybrids rated investment grade.

In these ways the expected return for an investor's portfolio can be smoothed with the regular income stream from the hybrid. With the yield curve signalling the market's expectation of rising interest rates, hybrid securities are finding favour because 80 per cent of the securities in the sector pay floating rate distributions - that is, the payments are referenced against either the 90-day or 180-day bank bill rate, so hybrids can provide a hedge against rising interest rates.

Also, with the average running yield of rated hybrids being around 5.5 per cent (including franking), hybrids are finding favour while cash rates are at a low 3.3 per cent.

Understand specific risk

In all circumstances, investors must understand that they are bearing specific risk to a company's performance. Distributions on some hybrids are specifically subject to company profits. Investors must also be cognisant of an individual hybrid's terms and conditions, especially the repayment profile. A good advisor should be able to clarify this for each hybrid.

For many reasons, several outlined above, investors have found hybrid securities a viable investment alternative, and with the hybrid market having remained a viable one during the turmoil of the credit crisis, it provides an easily accessible marketplace for investors to seek interest-rate style returns.

About the author

Michael Saba has covered Australian hybrid securities for more than 15 years at a number of Australian broking houses. He specialises in analysis and sales of derivatives to institutional clients, and was recently polled No. 2 in this sector in the 2009 BRW East Coles survey. He is Head of Derivatives at Evans and Partners in Melbourne.

From ASX

Information on Hybrid Debt Securities on the ASX website outlines the key features of ASX-listed hybrids, and looks at the latest style of hybrids and traditional hybrids.

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