Alongside the recent collapse in share prices has been a slump in the prices of hybrids, in many cases to below their issue price. I won’t say ‘I told you so’, because I didn’t, but my colleague Richard Livingston certainly has done on many occasions.
In not-so-cryptically-titled articles from ‘NAB Sub Notes: At sea and no lifejacket’ to ‘Bank hybrids: What could possibly go wrong?’ and, last week, ‘Commbank PERLS VII Capital Notes: Storm clouds brewing?’, Richard has explained time and again the risks with these complex instruments. But just in case he didn’t get through …
The idea behind hybrids is that they’re just that – a cross between the safety of cash and the risk of shares, with a yield also somewhere in the middle.
But here’s the thing: you can also give yourself a cross between the risk and return of cash and shares by … holding some cash and some shares. They even devote a chapter or two to this in text books on portfolio theory and give it a name, although I forget what it is. The idea, though, is this: you can give yourself whatever blend of risk and reward you like by mixing cash with higher risk assets. You can even take your risk beyond that of the higher-risk assets by moving from holding cash to borrowing it (we don’t recommend it).
Let’s see how this might work with the new issue of Commonwealth Bank PERLS VII Capital Notes. They offer a gross yield of 2.8% above the bank bill rate, currently about 2.6%, giving 5.4% in all. But if you were dead set on that yield (and bear in mind that we think chasing yield is generally a bad way to pick investments) then you could match it almost exactly with a portfolio of 50% cash on deposit with CBA (at 3%) and 50% in CBA shares (with a 7.8% grossed up dividend yield).
With this portfolio you’d be getting the same yield, but if everything travels along smoothly, then half your money should enjoy some growth in the income (and probably the capital over the long term) from the shares; and if everything goes to pot half your money will be safe (assuming it’s below the Government’s deposit guarantee).
Worst of both worlds
Contrast this with the hybrid, which gives you the worst of both worlds by limiting your return when things are going well and lumping you in the same boat as equity investors if it all falls apart. This is due to the ‘trigger events’, which are the raison d’etre of most new hybrid issues, because they mean they can be classified as a particular type of regulatory capital. The trigger events typically include a ‘capital trigger event’, which forces conversion to shares if the bank’s capital falls past a particular level and a ‘non-viability event’, under which APRA can use to force conversion if it deems that a bank is ‘non-viable’.
Somewhere in the middle, there’s a bit of the risk curve where the hybrids might do better if the bank does badly enough for its share price to fall and/or for its dividend to be cut, but not so badly as to trigger conversion. The hybrids are unlikely to get off scott free in this situation, though, and in any case it’s a relatively small area, that’s hard to define let alone price, and it would be dangerous to hang your hat on it. Some hybrids offer the opportunity for the investor to opt for conversion into shares if things go well, but this further adds to the complexity.
Beneath it all, complexity is at the root of all the problems with hybrids. Even the smartest bond traders have trouble pricing these instruments because of the unknowns (for one thing, APRA hasn’t clearly explained what might make a bank ‘non-viable’), so what hope is there for the rest of us? Issuers will inevitably use this complexity to give investors a bad deal. In fact, they literally owe it to their shareholders to try. These hybrid issues are commercial deals and every dollar they give away is a dollar that doesn’t go to their shareholders. Just like complex mobile phone plans, a little complexity can go a long way.
In investing, it’s normally best to keep things as simple as possible. So before getting involved with hybrids, think hard about whether you could achieve your aims just by tweaking your weightings towards cash and shares.
