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Bank hybrids response to equity market weakness

What’s the relationship between hybrids and equities when equity markets are weak? Probably the best comparison are the couples that appear on the Bachelor/Bachelorette: it’s ‘complicated’. There’s almost no correlation between the two assets most of the time, but sometimes there is and sometimes it can be material.

Price markdowns on bank hybrids and bank shares

The chart below details the drawdowns (markdowns in prices) for the Elstree Hybrid Index (Banks Series – yellow line) with the S&P/ASX200 Banks Accumulation Index (source IRESS – blue line).

Banks are actually a bit more volatile than the All Ordinaries Index but the bank index is a better like-for-like comparison. At the time of writing, bank shares are around 10% off their highs and hybrids are weaker by around 0.60%. If you are into statistics, that’s a 1 standard deviation move for both markets. You get worse than that most years.

The three circled areas are the periods of material weakness since the GFC and there are some common factors for each of those periods which aren’t present to date in the current sell off:

  • Fears of material economic slowdown/economic chaos (China slowdowns, Euro bank problems, Greece, Covid, etc)
  • Protracted equity market weakness
  • Big drawdowns. Bank equities had to have sold off by more than 15%.

This sell off is not echoing the previous three. It’s an inflation/too fast growth/interest rate led sell off and so far, it’s only around 10%. At this stage, it looks like normal noise for hybrids. We might see another 0.5% - 1% weakness before we get a full recovery, or this might be the bottom if equity markets stabilise.

Nothing to see on credit margins yet

The chart below gives a longer-term perspective of credit margins (source BofA/ICE, Elstree) for four types of credit investments: ‘BBB’ rated bonds, High Yield bonds, CoCo (non AUD AT1/hybrids) and Australian AT1/hybrids. The last data point is 26 January 2022.

Will the last month lead to a surge in defaults down the track?

That would be nasty. We would be adjusting hybrid portfolios if we thought defaults were coming.

But at this stage it’s a non-event. Our favourite indicator is the Kamakura Troubled Company Index (source Kamakura). The index details the proportion of companies globally in various degrees of difficulty. While it’s a black box model, with its major inputs being equity markets and volatility, it has been extremely accurate predictor of default activity with a 12 month lead time. Credit conditions are still in the 11% of best periods since 1990, despite the month of market falls and its 1/3 as scary as what happened during Covid. There’s no default threat yet. The chart below is the 26 January 2022 update.

Why you own hybrids

Here's our favourite chart that gives a rationale for investing in hybrids. It shows the amount (in dollars) you need to invest in the hybrid (red line) or equity market (blue line) at any one time over the past 21 years to have $1,000 today. Clearly, a lesser amount is better.

If you invested in our funds, the amount invested to have $1,000 today is even lower than that of the benchmark hybrid index.

The key takeaway is the delivery of similar return outcomes with lower risk. If you wanted to cherry pick data points, hybrids have outperformed equities since 2007 and also since just pre Covid. If you bought equities at the bottom of the Covid drawdown, you would have outperformed, but in general, hybrids have been great for much of the past 14 years. We think that is still a valid reason to invest in the asset class.


Norman Derham is Executive Director of Elstree Investment Management, a boutique fixed income fund manager. This article is general information and does not consider the circumstances of any individual investor. Elstree's listed hybrid fund trades on ticker EHF1. 


Campbell Dawson
February 03, 2022

Doug We've published the pre GFC drawdowns in another article: you can google it if you need to. The brief summary is that bank hybrids experienced an 18% drawdown which is almost entirely explainable by the capital losses from margins increasing from the 1% level we saw prior to the GFC to 5.5% (which is where they have topped out in the other very weak periods). If margins increased from the current 2.75% to 5% over the next year your capital loss would be c6.5% offset by 3% income , so a drawdown of c3.5%. There are other differences. Banks have doubled their capital since the GFC and prices of some bank hybrids in the GFC reflected a fear that they would not be redeemed. All these make using the GFC experience problematic. Returns. Hybrids are almost entirely floating rate so there has been no benefit from falls in interest rates. We've also published research that if you compare returns of equities to bonds over almost any long period, they rarely produce returns of greater than 2% better than the 10 year bond at the time you start your comparison. If that repeats, margins of c3% on hybrids may continue to provide returns that are comparable to equities. Thanks for the comments and for reading the article

Doug Turek
February 03, 2022

Terrific charts but is there some reason why they couldn't have started in 2001 when apparently you first created your useful Elstree Hybrid Index? It seems the key event of the GFC is missed and it would be useful to see the drawdown then. Also, well done comparing a hybrid to an equity in your last chart, as most compare hybrids to fixed interest investments. Of course a problem looking backwards with any fixed interest investment returns, is that they enjoyed wonderful starting high yields and won't today (ie. the 10 yr bond yield was 8% in '00 (hybrid 10%?) and is under 2% now and indebtedness limits its rise). Often the best predictor of future returns of a fixed income investor is the current yield (definitely not past performance) so perhaps one should just compare the current yield of the All Ords and hybrids. Your last chart is great but I question you can infer they will keep up with All Ords because they did. Put similarly I suspect a 30 year old fixed rate Gov't bond bought in 2000 would also have beaten the All Ords but a new one now only offers a prospective a 3% pa return for 20 years.


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