There’s more than one way to lose money with hybrids

Last week, ratings agency Standard and Poor’s announced it was reviewing global Basel III compliant hybrids and that it expects to downgrade more than 80 per cent around the world. 

This decision highlights the growing unease of the complex, high risk nature of the investments rather than the simple fixed income product that many investors believe they own.

While the returns look attractive, they are paid to compensate investors for taking on serious risk. Many investors have told me that despite reading the prospectus they failed to get much insight from it so here are some of the things you need to consider.

Firstly, the new generation of “bail-in” hybrids carry much higher risks than hybrids issued before the GFC and include NABPA, NABPB, WBCPD, WBCPE, CBAPC (Perls VI) and CBAPD (Perls VII).

They are specifically designed to allow the regulator to convert them to equity (shares) in times of crisis, which is exactly when most investors don’t want equity as the share price will be falling dramatically. For this reason, we consider them to be “equity hybrids” having more in common with equity than debt.

This “bail-in” clause is a very important risk but one that many investors don’t fully understand. This led the UK regulator, the Financial Conduct Authority last month to ban the sale of new style bank hybrids to retail investors while it assesses their suitability for the mass market. 

The Australian Securities and Investment Commission has been warning Australian investors about the complexities of hybrids for years although it is yet to take action.

As investors wake up to these risks, most hybrids have now slumped to trade below their issue price.

The obvious risks with hybrids (the capital trigger and non viability clause) are also the least likely. There are a number of other risks which can impact the price and your returns which you may not have considered.

1. Banks need to raise hybrid funding and the market reaches saturation at current pricing levels. Investors in new issues demand higher returns to invest, so new issues are more attractive than old ones. Investors sell out of old issues and the price of the hybrids drops.
2. Interest rates go up and the low margins the banks are paying on the hybrids now make it cheap funding for them in future and they decide not to repay or convert, but leave the hybrids outstanding and they become perpetual.
3. One of the global or local banks that you haven’t invested in breaches its capital trigger clause or is deemed non viable and investors worldwide see the result firsthand and understand the consequences. They sell down their holdings, impacting the price of your hybrids.
4. Years down the track a perpetual hybrid that has little chance of ever being repaid is trading at a substantial discount to its face value. The bank sees an opportunity to offer a premium over the trading price, but the price is still lower than the face value and investors sell, crystallising a loss. Suncorp, a financially sound bank did just that earlier this year.
5. A deteriorating bank is prohibited from making interest payments on the hybrids and the price of them declines as investors sell. Not to mention that you aren’t paid your income.

This list is by no means complete. There are a range of possible outcomes for investors that make hybrids uncertain investments even if the probability of breaching the capital trigger of non-viability clause is very low.

Hybrids are paying around 2.5 per cent more than significantly lower risk term deposits to compensate for a wide range of possible outcomes that are even difficult for analysts to determine. Fundamentally, you need to ask yourself if you are being paid enough for the risks you are taking.

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