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.
10 thoughts on “Hybrids – Debt and Equity’s Unattractive Offspring”
I’d go one further and say that it’s generally not even worth looking at any security that is neither at the top nor the bottom of a business’s capital structure.
Even holders of secured debt that is not super-senior have a mysterious habit of getting screwed over by liquidators and receivers whose only two interests are to maximise fees for themselves and to ensure 100 cents in the dollar is returned to the senior-most debt-holders (in that order of priority).
Love that description!
This resembles the so-called “Taleb Distribution/Payoff”.
IIRC, Graham implies in Security Analysis that the only time to buy hybrids is when they are distressed.
Very helpful Daniel.
Whenever I see any sort of hybrid being proposed or sold, I automatically think smarty pants financing which comes at great risk and cost to the investor. In more brutal terms ‘avoid like the plague’. In even more frank terms, think GFC and run a mile.
Unfortunately they are dreamed up and sold by the so-called ‘professional experts’ who investors should be able to trust. So, good on you Daniel, for at least explaining them in plain English, with a good example.
Why does that one not surprise me!!
Are hybrids really commonly owned by investors? I have never met an investor (sophisticated or otherwise) who didn’t think they were garbage. I have noticed that plenty of them like CBAs PERLS don’t seem to struggle for demand though.
A fantastic opportunity never arrive in the mail. Does it ever appear as a late night TV “informercial”.
I love the hybrid market and I’ve been using it for 14 years as a cash alternative. Certainly it can be tricky and ignorance is rife amongst those who participate but equally with those who don’t. That is what creates the opportunities. If you don’t know the differences between your NABHA’s and NABHB’s then its good advice to steer clear.
It sounds like you’re going to learn the type of lesson that Professor Market only teaches every fifteen years or so.
“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” Abraham Maslow
Agreed, but if you were paying 70c to the dollar for a hybrid, that changes the game. For example, svwpa…