What have you found in your junk email folder recently? Numerous notifications of inheritance (I didn’t realise I had so many deceased uncles domiciled in Africa)? Offers of companionship, predominantly the Eastern European variety? Once you’ve sifted through these you might also find several prospectuses for hybrids.
For those unfamiliar with hybrids, they are, as the name suggests, instruments that combines various features of debt and equity. And they vary greatly. Some pay a fixed rate, some variable. Some pay a franked component while some have a step-up in the interest rate at some future date. At a certain date in the future some can be redeemed for cash, while others convert to shares, some at a discount to the then share price. Some are perpetual and can only be redeemed by the issuer. And the list goes on.
But what they all seem to have in common is that when things are going well, their share price behaves more like debt, often trading close to their issue price or if you’re lucky slightly above it. But when things are going badly, they behave more like equity.
Just take a look at their share price charts during the Global Financial Crisis.
Actually, don’t bother. Let’s instead presume that an event like the Global Financial Crisis might never happen again in our lifetime and focus on what can happen in a more normal time. ‘When’ and ‘what’ being 2016 and Crown Resorts (ASX:CWN) Subordinated Notes II respectively.
Earlier this year rumours abounded that James Packer was about to take the casino operator private. Holders of these hybrids panicked and drove the price down 30%. Would Packer use a truckload of debt to buy up Crown’s equity? If so, this would greatly increase the credit risk of the company and leave hybrid holders at the back of the line behind other creditors. Worse still, would a privatised Crown stop paying distributions to hybrid holders? Compounding these fears was the possibility that hybrid holders wouldn’t get their money back at the first opportunity (known as the first call date) in 2021. Rather Crown could let the notes mature in 2075.
Not convinced about the pitfalls of hybrids? Perhaps the Crown hybrids are a more extreme example of what could go wrong. But since we’re discussing casino operators, how would you like to do deal? I’ll sell you a security with 100% downside (i.e. it could be worthless) and you get 5% or 6% per annum if things go well. Sound enticing?
Yet many investors have a significant part of their portfolios allocated to hybrids.
Hybrids offer investors the prospect of returns slightly above cash (like debt). But they can be volatile in bear markets (like equities) and carry the risk of permanent loss of capital (like equities). So over an investment cycle they tend to provide debt-like returns for equity-like risk. An investor should really want the opposite.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.