HYBRIDS

Convertible notes and preference shares have been around for centuries but up until relatively recently were generally rarities. In 1990 ANZ issued the first “converting” (rather than convertible) preference share which had a fixed, unfranked dividend and at maturity converted into a fixed value, rather than fixed number of shares. Coles Myer followed as did Westpac, News Corporation and Santos. Then National Australia Bank kicked off the issue of the “income securities” in 1999 (although Adelaide bank had really been the first with their “floating rate capital notes”) in 1998 and thus we had another type of ASX listed asset which was aimed at income conscious investors.

The early 2000s marked the issuance of “reset” and “step-up” preference shares. Bank of Queensland issued a reset preference share which was very much like the converting preference shares issued through the 1990s but the reset feature was a novelty. This feature allowed the issuer to offer new terms to the holders as the maturity date approached. It wasn’t cause for alarm as the holder could force redemption and therefore was not at the mercy of the new dividend rate resulting from the reset. Later resets were issued without giving the holder this option. The terms could be changed at the option of the issuer, presumably if they thought the market would accept them and not necessarily because existing holders would find the new terms as good as the old ones.

Step-ups, on the other hand, seemed to be somewhat more user-friendly. In 2001, in exchange for a maturing fixed-rate preference share, Santos issued a step-up. Step-ups were different in that if the issuing company did not give the holder cash or shares at the maturity date, they effectively began paying penalty interest. Thus there was an incentive for the issuer to redeem for cash or shares. Resets, in contrast, had no such incentive as they were issued on terms which were good until the first reset date (usually five years after the issue date).

As mentioned above, floating rate notes and income securities have been around since the late 1990’s. Now we are seeing a variation of these in the form of floating rate bonds. Bonds are typically higher in the pecking order than notes and thus are technically safer. Tabcorp, a BBB+ credit rated corporate, kicked it off in 2009 by issuing a bond which pays 4.25% on top of the bank bill (swap) rate and with a 2014 maturity date. Commonwealth Bank, which has a AA rating, recently issued a floating rate bond at 1.05% above the bank bill rate and has a 2015 maturity. Recently Bendigo and Adelaide Bank issued March 2014 bonds at 1.40% above the bank bill rate and, as with the CBA bonds, the price has struggled to stay at par. It looks as if 1% above the bank bill rate is not enough, even for a AA issuer.

Note there have been a few changes to the preferred recommendations as prices and yields have changed over the last month.

Tables

Here are the tables we present each week. For now just have a look over them and you'll begin to see the elements people are interested in when looking at fixed interest instruments. Price in this area is basically a function of how much they pay (interest rate) and their credit rating. The higher the credit rating and the higher the coupon the higher the price.

You will also note the broad categories that they are separated into. The most notable difference between hybrids is whether they are floating rate or fixed rate payers. Floating rate payouts go up and down with market/official interest rates. Fixed rate payers pay the same percentage rate of the face value on each payment date.

There are a few definitions at the bottom of the section.

Recommendations - For the "quality" income investor I have produced a table of preferred hybrid recommendations below. You can learn all about hybrids if you like, or take the hard work out of it and take the recommendations below. This is a list of hybrids that are at the quality end of the scale and will give you a decent running yield, often a modest capital gain and with little chance of getting you into trouble.

Summary of Current Preferred Recommendations - Recommendations collected from tables 2-4

Table 2 - “Bond-Type” Resets / Preference Securities

These are Bond type Preference shares: all cash flows are known. We know the price, what dividends and imputation credits will be received and what the redemption / exchange value will be. They have the features of bonds but dressed up as shares.

Table 3 - Income Securities Bonds and Notes - Preference shares: all floating rate, some are franked, some are not. They’re the same as the bond type prefs but the income along the way is variable not fixed.

Income securities are listed debt securities which pay a floating rate of interest. A typical income security will have a face value of $100, pay interest quarterly or semi-annually (at a margin above the 90 or 180 day bill rate) and have a minimum term of five years. Some are perpetuities.

Marcus Today assumes the securities will be redeemed for $100, although conversion into shares would be likely if the issuing company is not inclined to reduce its capital base.

Table 4 - Income securities and notes: all floating rate, all unfranked. Classed as debt rather than equity and thus rank ahead of ordinary shares and preferred shares.

Some definitions

• What is the “coupon rate”? This is the annual dividend or interest payment as a percentage of a security’s face value.
• What is meant by “exchange”? “Exchange” in this context can mean conversion to shares, redemption or repurchase at face value, or sale to a third party at face value, typically at the preference of the issuing company / trust.
• What is the “running yield”? This is the current return the securities are paying at the last market price. eg. the historical annual payment / current price = running yield. The pre-tax running yield is the grossed-up return after taking into account franking credits.
• What is the “pre-tax yield”? This is the sum of the running yield (see above) and the attached franking credits (if applicable). This allows an easy comparison between franked and unfranked income.
• How is the “yield-to-exchange” calculated? It is the interest rate at which cash flows from an investment are discounted in order to bring them back into today’s dollars. This is because a dollar next year is worth less than a dollar received now. It takes into account inflation and risk. For the financially / mathematically – minded the yield-to-exchange is the discount rate required to equate the sum of future cash flows to the current price of the investment.
• Redeemable: The shares are redeemable for a stated price either at any time or at a fixed date. Note the majority of preference shares are not redeemable.
• Cumulative: Any unpaid dividend accumulates and will be paid typically before a dividend on the ordinary shares. Again, most preference shares are now not cumulative.
• Convertible: May be converted into ordinary shares, at the option of the holder, in a given ratio either at any time or at a fixed date.
• Converting: May not be redeemed and will be converted into ordinary shares in a given ratio either at any time or at a fixed date.
• Mandatory Exchange / Conversion: Exchange will only occur if the issuing company’s share price is above a certain price, usually on a set date and/or for a number of days prior to the maturity date.
• Reset: Certain conditions, including dividend rate, exchangeability and exchange discount may be reset at predetermined reset dates. Holders may have the right to convert at reset dates.
• Step-up: An additional amount may be added to the existing dividend rate, usually in the event the issuer decides not to exchange.

Hybrids - an explanation

Hybrids. What are they? Are they plants? Yes but not the ones I’m writing about. Are they shares? Well, sort of. You can deal in them like shares and they have some relationship to shares. But they're not like normal shares.

In short they are like term deposits but issued by companies in the share market rather than the bond market.

They’re like term deposits because most of them pay you an interest rate for lending the company your money and you will be offered your money back after a period of time (redemption). In the latest ANZ “CPS 2” offering for instance you are being offered the opportunity to invest for up to seven years.

When it comes to paying you interest, each year is divided up into either two or four periods and they will pay you out two or four times a year. You have to read the PDS (product disclosure statement) of each individual instrument to know its terms, how much it pays, when and when you get your money back and how much you get (sometimes you get shares not cash). And like a term deposit, there may be a sting if you want your money out early.

But it’s their names which give away the rest of the story. “Reset Preference Shares”, Converting Preference Shares”, “Perpetual Exchangeable Resaleable Listed Securities”; sounds like shares to me and in fact, they are, because in the event the company that issues them goes bust, there is a pecking order of who gets paid and holders of most hybrids will rank ahead of ordinary shareholders.

If a company goes bust the creditors get first crack at the assets. Hybrid holders get the next bite. Ordinary shareholders are last cab off the rank. After all, most hybrids are designed as “preference” shares - the holders have preference over ordinary shareholders - and so they rank above ordinary shares.

Appendix – Additional Securities Information