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The perils of hybrids

Preference shares, more commonly known as hybrids in Australia, have become a staple in the investment diet for many retail investors and SMSFs. When economic times are good and companies are doing well, preference shares can provide steady dividends that are usually 1-3% higher than term deposits. However, as the tip of an iceberg warns of the substantial danger below the surface, the structure of hybrids and their performance in the global financial crisis both point to the risk of a shipwreck.

An age-old warning

Whilst this article mainly discusses the relatively recent experience of Australian investors with preference shares, the warnings on these securities date back to at least 1949 when Benjamin Graham wrote the first edition of his classic book The Intelligent Investor. Benjamin Graham is often referred to as ‘the father of value investing’ and the mentor of Warren Buffett, who said The Intelligent Investor is “by far the best book on investing ever written”. In the book Graham writes about the structure of preference shares:

 “Really good preferred securities can and do exist, but they are good in spite of their investment form, which is an inherently bad one … the preferred holder lacks both the legal claim of the bondholder and the profit possibilities of the common shareholder.”

He goes on to note the reasons why investors buy preference shares:

 “Many investors buy securities of this kind because they need income and cannot get along with the meagre returns offered by top grade (investment grade) issuers. Experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate safety merely because the yield is attractive.”

On when to buy preference shares, Graham argues:

 “Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity ... in other words, they should be bought on bargain basis or not at all.”

To help put these arguments into context, a break-down of the key negative features of hybrid shares follows with Australian examples.

Hybrids don’t have equity control rights

In Australia, if investors holding more than 5% of ordinary shares object to the current management or Board of a company they have a right to call for an extraordinary general meeting. The dissenting shareholder group can then propose to change the current directors with a view to new directors changing the overall direction of the company. Hybrid holders have no such rights even when their dividends stop, providing that dividends to ordinary equity have also ceased.

Hybrids don’t have covenant protections like loans or bonds

When a company fails to pay interest on its bonds or loans without prior permission from the lenders, it has contractually defaulted. This effectively hands control of the future of the company over to its lenders, which may ultimately result in insolvency with the Board formally handing its powers over to external administrators. Hybrid holders have no such contractual rights when their dividends are not paid. Their payments are at the full discretion of the Board and are also non-cumulative, meaning that a missed payment is forever lost. Whilst having no dividends might be an acceptable outcome for holders of ordinary equity who can also participate in capital growth, hybrid holders typically invest for regular income and get little or no benefit from the increasing equity value of a company. Holders of hybrids ELDPA (issued by Elders) and PXUPA (issued by Paperlinx) would be well aware of their lack of equity or debt control mechanisms, even though they haven’t received any dividends for many years.

Hybrids have no protections to stop the issuer from becoming excessively leveraged if earnings decline or if the company chooses to issue large amounts of senior ranking debt. Excessive gearing increases the risk that a company will switch off dividends to ordinary and hybrid holders for many years in order to reduce a substantial debt load.

Hybrids are extended in the bad times and redeemed in the good times

Whilst the Australian experience with preference shares is much shorter than the US that Graham wrote about, investors here have experienced the same negative outcomes stemming from not having a maturity date. Many investors discovered in the last decade that step-ups don’t guarantee redemption at their expected call date, with 12 widely-held securities (AAZPB, BENHB, ELDPA, MBLHB, MXUPA, NABHA, NFNG, PXUPA, RHCPA, SBKHB, SVWPA and TPAPA) still outstanding today that have gone past their expected call dates. Loans and bonds at these companies matured during the financial crisis, with new debt issued at significantly higher margins. Preference shareholders are still stuck with the pre-crisis margin and step-up levels.

The opposite side of giving the issuer control over the timing of redemption is now starting to become evident. AAZPB and TPAPA are likely to be redeemed in the second half of 2014. Another potential candidate for redemption is GMPPA, as Goodman is likely to be able to replace the preference shares with cheaper senior debt. GMPPA currently trades above $100 reflecting the relatively attractive returns in the eyes of the market. Current holders are at risk of seeing that premium disappear if the company chooses to redeem, as happened with the price drop of HLNG and HLNGA.

The key issue linking AAZPB, TPAPA and GMPPA is that investors who bought in pre-crisis would have much rather been redeemed during the GFC as replacement securities offered better value then.

Hybrids can convert to equity at the worst times

Most ASX-listed hybrids contain the right for the issuer to convert the securities to ordinary equity at specific times, most likely when the company is in financial difficulty and when ordinary equity is least desirable. For example, holders of Willmott’s WFLPA in 2009 were offered the opportunity to exchange into ordinary equity worth 22.9% less than the issue price of the hybrids. In 2010, Willmott defaulted on its debts with the ordinary equity and hybrids both wiped out.

Bank hybrids are now issued with a standard clause that they will automatically convert to equity if the Common Equity Tier One capital ratio falls below 5.125%. If this point is reached, the bank will have recorded substantial losses on its loans and shareholders are likely to question whether the bank will continue to survive. The prospect of a large scale dilution of ordinary equity will put additional downward pressure on the equity price. It may fall further still if hybrids are compulsorily converted and many respond by selling their newly-acquired equity as quickly as possible.

Recent vintage bank hybrids also contain a maximum conversion ratio limiting the number of ordinary shares that can be received in a conversion process. This means a hybrid shareholder can receive shares worth substantially less than the $100 issue price.

Hybrids have much higher drawdowns than bonds

The experience of many Australian investors during the financial crisis aligns with the patterns of preference share trading identified by Benjamin Graham. The graph below compares the ASX accumulation index, the Elstree Hybrid Index (an index that tracks a broad mix of ASX listed hybrids) and the S&P/ASX Corporate Bond Index using the data covering the seven year period from 2007 to 2013. This is an ‘apples with apples’ comparison as each index includes both capital and income return components. It shows a peak to trough fall of 47.2% for the equity index and 26.6% for the hybrid index, whilst the bond index fell by only 0.8%. The hybrid index did recover its losses much faster than the equity index taking 29 months compared to 71 months to return to the pre-crisis peaks, but bonds again proved to be far lower risk taking only 8 months.

The hybrid index may substantially understate the volatility many Australian investors actually experienced over the seven years, as some hybrid funds suffered peak to trough falls of approximately 40%. Ten securities defaulted and suffered a complete loss of capital whilst both Elders and Paperlinx still trade below 50% of the issue price and have not paid dividends for several years.

Conclusion

In the current times of low interest rates and low economic growth, many Australian investors are building their exposure to hybrids unaware of the risks they are taking.

Benjamin Graham warned of many of the above problems as far back as 1949. Investors then and still today chase yield in bull markets, sacrificing protection measures like covenants in the process. Value investors following Graham’s advice will take advantage of the current low yields on Australian hybrids to sell down their positions and realise substantial capital gains. If Graham’s comments on the cyclicality of hybrids again prove to be true, then they may once again be available at bargain basement prices.

Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.

6 Comments
Nic
July 18, 2014

It is disappointing that these anti-hybrid articles keep coming out every so often. Why none of the positives in your article Jonathan? These issues, and most of them are from the major banks or insurers, always seem to get compared to equity and yet they are so different. The banks and insurers in Australia are regulated by APRA and under the new Basel III rules, are safer from a collapse than they were under the GFC and they stood up very well then. When we invest in equity, we have to accept the volatility that goes with it. Hybrids are nowhere near as volatile and so become more of a yield play. Certainly hybrids shouldn't be generally bought for capital growth, but for yield, yes. As a higher yielding issue from very high quality credits, they represent a good investment to diversify the fixed interest portion of the portfolio allocation. I can hear the screams now - fixed interest? Yes, fixed interest. It must be accepted that the first thing we do when analysing hybrid issues with an intent to invest is to consider the likelihood of "point of non-viability" of the issuer. We must consider the protective regime that is APRA and the government. The default type concerns noted in this article assumes the worst, and yet we're told that its safe enough buying blue chip equities - where capital value drops at any time without 100% guarantee of dividends being paid. If you assume the major banks will always pay a dividend, you must equally assume they will always pay their hybrid distributions. (otherwise the dividend stopper would kick in). Yes we own bank equity, but there is just as much justification for owning the hybrid issues. Likelihood must be considered. Frankly, it's heartening to know that regardless of the number of negative articles on Australian hybrid issues, sophisticated investors in their multitudes, self managing their own Super, know better and are investing sensibly in these straight-forward instruments. And yes, they are sophisiticated and do know what they are buying.

Guy
July 28, 2014

I agree with Nic's comments.

The Big 4 bank hybrids issued in the last 3-4 years do seem to be treated differently by the market and all trade positively within 6% of their face value. To me they are less risky than other company hybrids. Am I wrong Jonathan?

David O'Hanlon
July 18, 2014

Very good article Jonathan

sulieman
July 17, 2014

Liam

Unfortunately you can't really back test the new hybrids in that way as the banks now have higher tier 1 capital requirements.

The non viability clauses are due to the banks not calling the hybrids in the gfc, now forcing them if the same were to occur.

The issue you'll find isn't so much the conversion but at what factor they convert. They usually have a floor on the conversion factor of around 55% of the starting so a conversion is likely to result in a huge haircut at the same time

Liam
July 17, 2014

Has anyone actually done the figures on how one of these newer hybrids from the Big 4 would have performed in the GFC if the Common Equity Tier One capital ratio had fallen below 5.125% and triggered a conversion. Having seen the CBA price drop to the $20s and bounce back to $80 maybe the conversion would not have been a bad outcome!

I realise that a conversion would also dilute existing holdings so it could make a bad situation worse and there is no guarantee of a recovery but with these bigger banks and Government intervention in terms of GOVT Guarantees at times of crisis, one has to question if the downside is really as bad as expected.

Warren Bird
July 16, 2014

A good summary, Jonathan. I agree with you in general. There are some hybrids that are reasonably well structured and worth looking into, at the right price, but you have to be highly selective.

And with most hybrids, if you like them for their 'yield' then why not buy the company's equity? Don't just take the dividend as your income, but sell down a little bit regularly so that your cash flow is at least as good as the hybrid's yield. If the hybrid performs without any hiccoughs then the equity is likely to do even better. You'll have been able to use your cash flow as income, but your capital will have grown. If you don't like the company's equity then you shouldn't like a hybrid either!

Well managed equity income funds do just this sort of thing.

 

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