Hybrid Securities

Looking for a high-yielding, defensive investment in our volatile market is getting harder and harder.

Term Deposit Rates and Government Bond Yields have fallen dramatically on the back of the RBA’s efforts to stimulate the Australian economy. An alternative to Term Deposits that we have been using for many of our clients over the last 10 years are hybrid securities.

In its simplest form, a hybrid security is a company borrowing money from the general public at a promised rate (margin) above a variable portion, generally this is the 90-day bank bill rate. The most popular issues of recent have come from Australia’s big 4 banks, issuing margins of around 5% above the bank bill swap rate.

This means that even if Australian interest rates and cash rates were to drop to 0%, an investor would still receive 5% pa. These securities also have a designated pay-back period, this is basically a promise to pay you back your initial investment after a certain amount of time.

We consider that these hybrid investments make up a defensive portion of an investment portfolio. Coupled along with other asset classes like cash and fixed interest (term deposits or government bonds), they provide a secure income flow but they can exhibit some volatility as they are traded on the stock exchange.

In the current low rate environment, hybrids stand out from their defensive counterparts because of their attractive income payments. When comparing the very attractive 6-7% interest payments to the 2-3% received from cash and fixed interest, you may wonder why all defensive investments are not allocated to this asset class. The reality is that hybrids have additional risks to cash or fixed interest, which is why you are rewarded with a higher interest payment and why it shouldn’t be your only defensive asset.

A hybrid involves a promise to pay you back your initial investment after a certain amount of time. This promise doesn’t mean the value of the asset is fixed for the assets duration. The very nature of the hybrid allows it to be traded on the market like all other equities, allowing the capital value to fluctuate between purchase and maturity.

With any security traded on the market, the demand and supply of the product determines the price at any given time. Let’s say you buy a hybrid for $100, in a year’s time it may rise to $102 or fall to $98. This is the volatility risk associated with hybrids, which aren’t associated with other defensive assets such as Term Deposits.

As discussed above, hybrids can be volatile and this is the reason we usually advise our clients to hold them to maturity.

We also usually stick to investing with the ‘Big 4” Banks as this gives us a level of comfort that the issuer will be around to continue to pay the interest and return your capital at maturity.

In today’s low rate environment we believe Hybrids have a place in a diversified investment portfolio. Particularly, we see our ‘Big 4’ banks as secure companies who are currently providing attractive yields for their hybrid issues.

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