Risk comes from not knowing what you are doing – Warren Buffett
I sometimes wonder if Warren Buffett is better known for his succinct and pithy quotes rather than his investment prowess. Irrespective, there is great wisdom to be had from reflecting on what he has to say from time to time.
Prior to the current stock market machinations, many investors switched out of the safety of cash and term deposits and into convertible notes, more commonly known as hybrid securities, in search of higher yield, this begs the question, did investors fully understand the risks they were taking and was it worth it?
Convertible Notes / Hybrids
Australia's major banks, other financial institutions, and even some corporates, have been very active in rolling out hybrid issues to investors over many years to meet their regulatory obligations.
More than $5 billion of new hybrid issues hit the market in 2019, taking the total number of hybrid issues listed on the ASX to 54, worth a combined $45.7 billion.
The biggest hybrids listings of 2019 were a $1.87 billion issue by NAB in March, paying an interest rate of 4.9 per cent, a $1.65 billion issue by Commonwealth Bank in November, paying a rate of 3.93 per cent, and a $905.5 million issue by Macquarie Group, also in March, paying a rate of 5.04 per cent.
All the issuers had no trouble filling their capital needs. Offering relatively good yield returns in comparison with government bonds and bank term deposits, there is an obvious attraction.
Given that Australia's major banks make up the bulk of the issues, hybrids could be construed as ‘safe’. However there is no such thing as a free lunch, and it’s very important investors understand the complexities of hybrids and the capital risks they may entail in the future.
For starters, hybrids rank just behind equity in terms of risk, as illustrated in figure 1, for the ANZ Convertible Notes (Tier 1 Regulated Capital):
Source: www.bondadviser.com.au - ANZ Capital Notes Research report - 17/12/2019
Potential Capital Loss…
The price of hybrids fluctuate, particularly in times of extreme volatility such as in 2016 and more recently with COVID-19.
This means investors’ capital is at risk and they face a potential loss if the hybrid is sold below the purchase price.
On 23 March 2020, the face value of the ANZ Capital Notes 2 dropped to $88 or 12% which was comparable to the drop experienced during the 2016 market correction as illustrated below.
Some of the other underlying risks faced by hybrid investors include:
|Conversion risk||Most hybrids are structured to allow the issuer to force a conversion to equity at its discretion, irrespective of the initial prescribed maturity date.|
If the issuer's share price has fallen at the conversion date since the time of the initial investment, investors will in effect take a capital loss. During the Australian equity bear market of 2007-09, hybrid securities produced negative monthly returns on a regular basis, unlike fixed income securities which rarely produced negative returns over this period.
|Deferral Risk||Another factor with hybrids is deferral risk, whereby issuers can choose to indefinitely defer making interest payments. Most issues usually include wording to the effect that the issuer has no obligation to make up any missed payments.|
|Liquidation Risk||Furthermore, in terms of recouping funds in the event of a company default and subsequent liquidation, hybrids rank below senior and subordinated debt (bonds), although investors do have priority over common stockholders|
|Interest Rate Risk||There is also interest rate risk in hybrids, which exists for holders of both fixed and floating rate payment hybrid securities.|
For fixed rate hybrids, the inverse price/interest rate relationship will mean that when rates rise, prices fall; and when rates fall, prices rise. The level of interest rate sensitivity will depend on the duration of the security.
As such, if an investor sells the hybrid before maturity the price may have moved unfavourably. Similarly, the price of floating rate hybrids is also inversely impacted by interest rate movements.
Additionally, floating interest payments are directly impacted by general interest rate levels. If rates rise, interest payments rise; if rates fall, interest payments fall. A significant fall in interest rates would substantially diminish the returns for investors in hybrid securities.
Keep this in mind in the context of the likelihood of further cuts to interest rates.
|Liquidity Risk||Current and would-be investors should also be aware of liquidity risk. For some hybrid security holders who wish to sell, a lack of market liquidity means they may find it difficult to locate a buyer willing to pay a high enough price, or in a stressed market scenario, may not be able to redeem their capital.|
In short, hybrids may be one way of capturing yield, but for some they could become a stretch too far if equity market conditions worsen. In past market downturns, because of their inbuilt equity characteristics, hybrids have been poor performers for investors.
A Considered Approach
At WARR HUNT we believe that bonds and cash play a very important role in dampening equity market volatility and should not be underestimated. Bond strategies holding high-quality, investment grade fixed interest securities are a much lower-risk option and perform the important role of adding ballast to portfolios to counterbalance potential financial shocks in equity markets.
It would be remiss not to end on a quote from Warren Buffett:
the stock market is a device for transferring money from the impatient to the patient