Hybrids: The asset turbocharging returns for Yarra Capital

Angus Kennedy

Livewire Markets

When thinking about a capital structure, on one end of the spectrum you have senior debt and on the other, equity. The securities in the middle can be unloved at times, but those who know how to find value here simply can't get enough.

This region is where you will find hybrids, the assets that have a little bit of everything to them. Roy Keenan, the co-head of Australian fixed income for Yarra Capital Management, has a particular passion for these instruments and knows the power they have when it comes to boosting a portfolio's yield while managing risk. 

The role they play for us is that they give us good sector exposure. Hybrids aren't just banks and insurance - they can also be issued for the corporate sector. So we tend to use hybrids for our diversification purposes, but more importantly, investing across a capital structure of a company gives us that ability to find value...(and) get paid for the risk that we're taking

The joy of hybrids is that they can differ immensely from one issuance to the other - and with this diversity comes mispricing and thus investment opportunities. 

In this interview, Keenan discusses the role hybrids play in the Enhanced Income Fund, their approach to assessing these securities and shares a set of hybrids the fund recently invested in. 

Transcript has been edited for clarity.

How would you explain the basics of hybrid securities?

The best way to think about it is that hybrids sit somewhere between senior debt and equity within the capital structure. Where they sit between senior and equity will come down to the terms and conditions of the securities, for example, if they can miss coupon payments or have a conversion to equity. Fundamentally the difference is that senior credit will always just get maturity. With a hybrid, you basically have terms where they can be called earlier, or they could convert to equity at some point under certain conditions. They always sit above equity because equity holders, as we always say, get the blue sky. Hybrid holders and senior holders just want their money back and their coupons, which is really important.

What role do hybrids play in a portfolio?

Hybrids are a passion for me. I've been involved with them since the mid-90s and they're not well understood by the marketplace, even though retail investors do invest in them.

I think the most important thing from a research point of view for us is, as I was taught at a very early stage in my career, to never assume anything. So reading the terms and conditions of a hybrid is really important.

The role they play for us is that they give us good sector exposure. Hybrids aren't just banks and insurance - they can also be issued for the corporate sector. We tend to use hybrids for our diversification purposes, but more importantly, investing across a capital structure of a company gives us that ability to find value.

We have pretty much one rule as an investor: get paid for the risk that we're taking.

I think that's important. We look at senior credit from a bank. We look at Tier 1, Tier 2, all of it. But we are always trying to strive to find best value because the worst thing you can do from a credit point of view is to actually invest and not get paid for the risk that you're taking.

How do you go about assigning your own credit ratings to investments?

It doesn't matter if it's a hybrid, but any company or security where we are lending money or investing in, we will always look at the financials, the ESG, the business profile, and where they sit in the market. That's important.

I talked about the importance of experience, and I'm very lucky that I've got an experienced credit team who all contribute to that rating process. I always say it's not set in stone. We're always looking for ways to improve.

From my perspective, I think it's important that we look at companies, look at cash flows, and value companies the way we want to, not how other people do.

And what we find is that by assigning a Yarra rating, we're taking many things into consideration and we are forming a view on that company, which could have inputs from our equity team. That is also quite unique to our process - we work very closely with our equity team.

Another point about the Yarra rating is we apply that to the senior level and then in the case of hybrids, we will form a view on things like the ability of a company not to pay a coupon or where you sit in the recovery if a company were to default. We apply all those things to the senior rating, but then we look at the terms and conditions of a deal and assign a rating to the subordinated credit, whether it be Tier 1, Tier 2, or even just subordinated debt. That's really important to form a view on how you see those terms.

What is an example of a hybrid security that you have invested in?

I think if I look back on the first quarter of 2022, for the first time in my career managing the Enhanced Income Fund, I've bought bank Tier 1, and bank Tier 2 paper. I can't remember a period where I've done that and it probably highlights to me that looking at where we've got to with markets this year, at some point getting paid for that risk showed during the quarter.

We felt senior was really cheap and hence we invested there. We exited, and then moved into some Tier 1 Commonwealth Bank and then moved into Tier 2 later on in the quarter.

I think that highlights that having an open mind and a flexible approach to investing in a bank capital structure gives you that flexibility.

I have a rule of thumb that to move from senior credit to Tier 2, I want to double the credit spread that I invest in, and then to move from senior to Tier 1, I want to get four times a spread or double Tier 2 spread to Tier 1. That rule of thumb has served me very well to identify value over a period of time.

Having that ability to rotate along a bank capital structure is important. This quarter I bought CBA senior, CBA Tier 2, and CBA Tier 1, which is quite unique.

What do the different levels of hybrids mean for investors in a risk-reward context?

In senior unsecured issues by a bank, generally, the maturity is defined, it has no extension risk and no ability to convert to equity. If I bring it back to a rating perspective it is AA- from a bank's perspective, so really high quality. Today, it trades at around 83 basis points over what we'd call swap (how much credit spread that we're returning). We picked Tier 2 CBA up at 190 over swap, and the difference between senior and Tier 2, is that Tier 2 have an ability to convert to equity, mainly based on non-viability. This means much more risk than senior, hence why you're getting paid 190 versus 83 and essentially at a ratio about 2.3 times - which looks pretty good.

Moving into Tier 1, you introduce the ability of a bank to miss a coupon and conversion to equity on non-viability based on defined conversion terms. But you also have another factor which can be that if a bank's capital falls below five and one-eighth, then you could be converted to equity.

But in my view, Australian banks are of the highest quality, and investing in major bank Tier 1 and Tier 2, is the cheapest form of enhancing your return because fundamentally they are quality businesses in a quality economy. In my view, if there are times when it can get tough, equity holders will fundamentally fund the banks, which is a great way to enhance return in something like the Enhanced Income Fund.

Access to regular, stable income

The Yarra Enhanced Income Fund seeks to deliver higher returns to investors than traditional cash management and fixed income investments. Learn more via the Fund profile below, or by visiting Yarra Capital's website

Managed Fund
Yarra Enhanced Income Fund
Australian Fixed Income
Yarra Funds Management (ABN 63 005 885 567, AFSL 230251) is the issuer and responsible entity of the Fund. The information provided contains general financial product advice only. It does not take into account any personal objectives, financial situation or particular needs. Before making a decision to acquire, hold or continue to hold an interest in the Fund you should consider the appropriateness of the advice in light of your own or yours or your client’s objectives, financial situation or needs. Prior to investing in the Fund you should obtain and consider the PDS and TMD available at https://www.yarracm.com/pdsupdates. Past performance is not an indication of, and does not guarantee, future performance. Forward looking statements should not be construed as providing any assurance or guarantee as to the results that may be realized in the future. Portfolio holdings are as of the date indicated and may not be representative of future investments. The holdings shown may not represent all of the portfolio's investments. Future portfolio holdings may not be profitable. The information should not be deemed representative of future characteristics for the strategies listed herein.

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Angus Kennedy
Content Editor
Livewire Markets

Angus is a Content Editor at Livewire Markets. He has previously interned in the Global Investment Research division at Goldman Sachs, covering resources and small caps.

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