ASIC issues hybrid securities warning

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ScreenHunter_1104 Feb. 04 17.02

By Martin North, cross-posted from the Digital Finance Analytics Blog.

The Australian Securities and Investments Commission (ASIC) yesterday released information to help potential investors understand the complexities and risks of hybrid securities. Given the recent number of issues, and their popularity amongst self-managed super investors, this is timely. Background information also provides insights into the funding arrangements of the banks.

Around $18bn was raised through ASX-listed hybrid securities in the 18 months to July 2013. Data provided by ASX shows the range of issuers during this period.

ASX1Hybrid securities are attractive to issuers because they can structure the security to address tax, credit rating, regulatory capital or accounting needs. Whilst there was a period post the GFC when issuers held off, both banks and corporate entities have been active more recently.

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Banks are able to use the instruments as capital to meet the APRA requirements as described in the Basel Committee on Banking Supervision. Bank issued hybrids to quality must have “loss absorption” features which enables a bank to reduce its liability in time of financial distress, buy conversion or write-off. The rules were tuned during 2013, which explains the spate of securities issued by the banks, to replace non-complying paper.

Other corporate entities are able to access funds tuning the issues to meet specific requirements, and to engineer an appropriate rating from the credit rating agencies. Hybrid structures with a high quasi equity content were attractive in 2013, though now some of the rules have changed, so may be less attractive now.

Hybrid securities are mostly debentures, but can combine characteristics of both equity and debt instruments, and may have features which include long maturities, potential to convert to equity, or deferral of interest. They may be called “capital notes”, “convertible preference shares” or “subordinated notes”.

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As a result investors need quite a sophisticated understanding of how they work to appreciate the potential risks attached to this type of security. These securities are often distributed through brokers, financial advisory firms, wealth management entities, private banking or stock broking entities. Often the issuer prospectus is “supplemented” with other sales documents.

ASIC makes the point that whilst 34% of Australians invest in shares, investors in hybrids is concentrated, somewhere around 75,000 investors, and two-thirds of which are in self managed superannuation funds (SMSFs) who are attracted by the high yields. About half of these investors seem not to reply on their financial advisors. We noted these trends in our recent note on SMSFs.

ASIC is warning that potential investors need to look beyond the brand, to the structure of the securities, and the risks involved:

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  • “long investment terms, circumstances which permit early redemption, and the danger in expecting issuers to redeem the instrument at the first opportunity
  • the ability or obligation for issuers to defer interest payments if their financial position deteriorates, and how long these can remain unpaid
  • the subordination of the instrument, the level of senior debt ranking ahead of hybrid investors, and the implications if the issuer fails
  • the ability for investors to exit their investment prior to maturity, that market prices for hybrid securities may be volatile and experience low liquidity, and that selling their investment on market may incur a capital loss.”

In essence, investors are receiving apparently more attractive returns than standard bank deposits, because of the additional risks and uncertainties attached to hybrids. These risks are hard to pin down, because external future events may impinge on the security, and the potential activation of its conversion features. These trigger events are hard to predict. In addition, market prices may become volatile, and most hybrids are unsecured, so will rank behind other creditors.

The Money Smart site includes some war stories to try and highlight the issues involved. It is worth a visit.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.