Bank Hybrids: The devil is in the detail.

We are often surprised that retail investors with whom we speak, are blissfully unaware of the risks involved in owning hybrids. ASIC and the banks have done a great job disclosing the risks, however, the message does not seem to be relayed effectively by financial intermediaries. We hope this note shines some light on the well documented but lesser understood risks surrounding hybrid investments.

So what is a hybrid? A hybrid security is an instrument that combines both debt and equity characteristics. Bank hybrid securities generally pay a distribution based on a fixed margin above a benchmark, like the 90-day bank bill swap rate. However, unlike bonds, they may be converted into equity under certain circumstances.

Bank hybrid securities have been sold for some time in Australia. Banks love issuing hybrid capital as it is a cheap source of funding and treated as regulatory capital by the Australian Prudential Regulation Authority (APRA). Regulatory capital is the loss-absorbing buffer that protects bank depositors from loss. A recent offering by one of the major banks defined the hybrid investment as “perpetual, exchangeable, resaleable, listed, subordinated, unsecured notes”. Confused? Let’s unpack some of these terms below.

Exchangeable

Hybrid owners need to be aware that the issuer may be forced to exchange the instrument into ordinary shares if directed by APRA. The conversion is triggered when the banks regulatory capital ratios or bank ‘viability’ is under pressure. Therefore, investors should be aware that conversion into ordinary shares, although a remote possibility, is still a possibility. Unfortunately, if this happens, it would occur at the worst possible time, when bank performance, financial position, and solvency are under threat.

Payments are not guaranteed

Unfortunately, the distributions are not guaranteed. Distributions on bank hybrids are at the discretion of the issuer and subject to the distribution payment conditions being satisfied. Distributions that are missed, do not accrue and are not required to be paid. However, failure to pay a distribution would prohibit the issuer from paying a dividend on their ordinary shares. Something most issuers would be reluctant to do.

Unsecured and Subordinated

Finally, investors need to be aware that bank hybrids are unsecured and subordinated. We may be stating the obvious here, however, it is worth pointing out that hybrids are not protected by the government. Furthermore, the hybrid investor ranks behind all other creditors, except for ordinary shareholders, in an insolvency event. Basically, hybrid investments behave like debt on the upside and equity on the downside.

We’ll leave the last comment to ASIC (Source: Money Smart Website):

“Warning: If the bank experiences financial difficulty, bank hybrids can be converted into bank shares, which may be worth less than your initial investment, or even written off completely, meaning you could lose all of your capital.”

We hope this article is a timely reminder that hybrid securities do carry some level of risk regardless of the way they are marketed by financial intermediaries.

Disclaimer:
The information provided in this document is of a general nature only, is not personal investment advice and has been prepared without taking into account your investment objectives, financial situation or particular needs (including financial and taxation issues). Investors should read and consider the investment in full and seek advice from their financial adviser or other professional adviser before deciding to invest.