Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

How risky are bank hybrids and are they misrepresented?

Question from Rob Prugue: Bank hybrids and other investment securities are NOT term deposits. Corporate notes, convertibles and debt issued by many banks are being touted by some as akin to term deposit. Oh really? Hybrids and convertibles as term deposits?  If they sincerely believe this to be true, what on earth are they doing advising. And if they know it’s false, why don't they just say so?

Here’s a perspective from Philip BayleyPrincipal, ADCM Services. This comment first appeared in Banking Day.

Why has the listed bond market developed as a risky, high yield market?

The vast majority of the funds being invested in high yield notes are coming out of self-managed superannuation funds that are intended to provide for beneficiaries’ retirement. Should regulators be concerned that the listed bonds are a risky, high yield market? The answer is yes.

The regulators, issuers and other market participants are well aware of the risks posed by the notes and yet some mums and dads can’t get enough. Earlier this month, NAB launched its second converting preference share issue for the year and, just as with the first issue in March, demand was sufficient to allow NAB to double the size of the issue to A$1.5 billion.

What is the attraction of a hybrid security that offers all the downside risks of equity for little reward? Is there an element of mis-selling in the marketing of these instruments?

Much emphasis is placed on the instruments offering a dividend of 325bps over the bank bill rate, in the case of the NAB CPS II. This sounds like a high yield but at current bank bill rates, it means an annual return of about 4% plus franking credits.

Do mums and dads realise that they are being targetted for these offers, because institutional investors would demand a margin over the bank bill rate that would be closer to twice the size of the one on offer? Institutional investors have a much clearer understanding of the equity-like risks that the instruments entail.

Clearly, retail investors do not have access to the same level of information available to institutional investors and for the most part, do not have the same level of understanding. In NAB’s case, many mums and dads simply perceive the converting preference shares to be a better yielding alternative to a term deposit.

Retail investors rely to varying degrees on the recommendations of their financial planners and advisors, who in the case of the former at least, rely on the research houses to provide research and recommendations on these instruments. And while institutional investors have access to credit ratings to help inform their investment decisions, very few issuers of listed bonds have chosen to have their bonds rated.

In fact, credit ratings have been actively avoided by issuers of listed notes. The wholesale market demands credit ratings but in the listed market issuers see ratings as an unnecessary expense and who wants to highlight the risks involved anyway?

This attitude is underlined by the spate of unrated, unlisted bonds that have been issued to supposedly 'sophisticated investors' this year. This is something else that the financial system inquiry will no doubt be concerned with, in relation to the development of the corporate bond market.

Sophisticated investors receive none of the prospectus provision protections provided to retail investors. Under regulation 6D.2.03 of the Corporations Act a sophisticated investor is defined as a person with net assets of A$2.5 million or more or whose gross annual income in the last two years has been at least A$250,000, as certified by their accountant.

These days neither test is particularly hard to meet, and who says they know anything about investing anyway? Having assets or a good income does not an investment professional make.

Do the sophisticated investors who have bought the unrated, unlisted bonds offered realise the credit quality of each of the issuers would likely be assessed as being in the single B category by any of the three major credit rating agencies? This is well into junk territory, so let’s hope the yield on the bonds provides sufficient compensation for the risk.

The Financial System Inquiry needs to consider ways to increase the flow of reliable information to investors, both at the time of making the investment decision and afterwards. Ideally, this information will be made freely available to investors by the information providers, and only by those providers that have joined the Financial Ombudsman Service.

Such a requirement would go a long way towards to creating well-informed investors, 'sophisticated' or not, and promote a listed corporate bond market in the form originally intended.

 

5 Comments
Sulieman Ravell
January 14, 2014

Hi Warren

I should firstly say I'm in agreement with you that I would rather invest with bond managers (for the majority of my fixed income) and perhaps I should re-qualify my relative to risk statement. This is on the basis of holding to maturity. I hold them because they misprice and behave differently to other asset classes and regularly misprice allowing us to pick up added returns. The returns for the risk then become more worthwhile. I suspect that if bond managers were able to take advantage of these pricing movements, they would, unfortunately, any manager worth his salt is unable to take a reasonable trading position without moving the market against themselves.

I'm also in agreement that investors need to look beyond a household name, tail risks are becoming more frequent. A good reminder for retail investors would be to consider a company like RBS in the UK, which was the UK equivalent of CBA, perceived as indestructible. The key difference is arguably just geography.

Having said that, I think its a little unfair on the hybrid sector to say there are several bond funds that are highly competitive with (retail) hybrids. The market has been too narrow until late to show comparable performance and therefore the only comparable becomes the current yields on offer. In which case, its unlikely you'll get anywhere close to hybrid yields. Factor in the 0.5%pa (plus potentially a platform fee and adviser fee), you can see why retail clients flood to direct hybrids and why they often feel their (non-equity) investment options are limited to TDs or hybrids.

I think the behaviour of the asset class itself provides value in addition to just the yields. Negative correlation allows you to take additional risk in other parts of your portfolios and allocating more to higher risk assets such as equities.

If it was a case of just investing in investments that were cheap why would anyone be allocating to bonds when TDs are still paying historically (relatively) high returns for retail investors. Fund managers don't because they can't access the same rates.....

Warren Bird
January 11, 2014

The way I look at things is that if I don't think something is value for money I don't buy it, even if it means accepting a lower yield and potentially lower return. Buying poor value is a sure way to end up losing capital.

But, I am not saying that hybrids don't offer value for risk. Many actually do. I'm simply saying that investors need to be aware that it's not just a case of saying, "company XYZ is a household name so it's hybrid must be safe". The true nature of the security's risks need to be understood and evaluated. And then you need to limit your individual exposures so that if a tail risk event happens it doesn't wipe you out.

There are several bond funds which even net of fees are highly competitive with hybrids. I'm not here to market any in particular, but most of the platform providers who've done manager research have quite a few to choose from. I'd rather pay a fee of 0.5% or a bit more for a credit risk portfolio to be well managed and diversified than buy half a dozen hybrids and hope that we don't get tail risk events.

Sulieman
December 28, 2013

Whilst I agree that hybrids don't offer value for money relative to the risk, what are the alternatives for retail investors?

A bond fund that charges an 0.5-1%pa fee? We're then looking at TD returns for greater risk

The other attraction is that hybrids behave completely differently to both equities and bonds and often misprice in the secondary market.

So whilst I agree, the tail risks are much greater than investors understand, I think there are some attractions to what I consider a separate asset class

Warren Bird
December 13, 2013

During the second half of 2012 I did a series of roadshow presentations to advisers on hybrids. Main message was about tail risk. Sure, most of the time you will get paid the reasonably high yield by issuers who you are familiar with. But if something goes wrong, there is a lot of downside risk. The question has to be asked: if the things that make it a hybrid rather than a corporate bond are triggered, can I live with the consequences?

Consequences including: conversion to equity in a company that might be going backwards fast; outright capital losses from a default; or conversion from a security expected to mature soon to something that is perpetual.

The latter is one of the least understood. EG bank hybrids are callable after a moderate period, such as 5 years. Most people expect the bank to call the bond, so they compare it to a 5 year TD. But, it is not actually the bank's say whether they can call it or not. It is APRA's. If APRA believes that bank capital is under pressure - say from a sharp fall in house prices and pick up in mortgage arrears - then they will override the bank and force them to keep the hybrid to shore up their capital.

Now APRA doesn't give two hoots about what this does to an investor's portfolio. APRA only cares about bank solvency so that depositors are protected. Hybrid investors are in the firing line to be adversely affected.

None of this means you should avoid hybrids. But you do need to understand the tail risk of owning them. As they say in the classics, there's no such thing as a free lunch. Hybrids pay higher yields for a reason.

Whether they pay high enough to be good value is another question that I'm not going to discuss here beyond saying that some do and some don't. (My mate Rudi Minbatiwala at Colonial First State is pretty good at working out the answer to that question.)

Mark
December 13, 2013

Good article and I agree with many of the sentiments; basically on a risk-adjusted basis I do not believe that the recent bank hybrids offer attractive returns.

However, I would note that your statement, "credit ratings have been actively avoided by issuers of listed notes" is not true. Largely thanks to ASIC, the three major credit rating agencies have not applied for and do not hold a retail license in Australia, so are explicitly prohibited from offering credit ratings on any product that is targeted towards retail investors.

I agree that this is a crazy situation and should be addressed sooner rather than later. The information that the rating agencies would impart would go some way to filling the vacuum, which is currently filled by conflicted advice from various parties. Having said that, investors also need to be educated to look beyond the headline yield/return and adjust that for the associated risks involved.

 

Leave a Comment:

     

RELATED ARTICLES

Nassim Taleb on managing investments for rare events.

Are rising oil prices bad for Australian shares?

We need to talk about risk

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Welcome to Firstlinks Edition 464 with weekend update

The 2021 Census reports that Millennials are now the largest generational group in Australia. While we are increasingly secular and culturally diverse, our differences are far more accepted than the way the US is heading. And please take our short retirement survey.

  • 30 June 2022

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.