FIIG - The Fixed Income Experts

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Why hybrids are too hot, term deposits are too cold and bonds are just right

by David Moore | Oct 13, 2014

Investors can invest in three broad asset classes: property, equities and fixed income. Fixed income is the defensive part of an investor’s portfolio that is used to preserve capital and deliver a reliable income stream.

Until four years ago investors needed $500,000 to own a single corporate bond. This restricted self-directed investors to bank deposits and ASX listed hybrids for the defensive part of their portfolio. These investors are now getting squeezed: earning very low rates of interest on deposits, and accepting more risk on their hybrids.

Fortunately, bonds offer higher returns than deposits without accepting equity-like hybrid risk. With deposit rates continuing to fall, and hybrids becoming increasingly risky, the case to add corporate bonds to a portfolio has become more compelling.


The Challenger Capital Notes issued in September were described as discretionary, non-cumulative, convertible, transferable, redeemable, subordinated, perpetual and unsecured. Confused? You’re not alone. Hybrids are complex.

Also, since 1 January 2013, hybrids issued by banks have become riskier with the inclusion of the “non-viability clause” which allows the regulator at its sole discretion to order hybrids to be converted into equity or written off should they deem that the bank in question is at the point of non-viability.

The fact that in a downturn, the new breed of hybrid may perform just like equities and do not protect investors like fixed income should, is articulated in Craig Swanger’s article: FIIG Securities says new “bail-in” hybrids are equity risk, not fixed income. But it’s not just us ringing the alarm bell on hybrids. Read Chris Joye’s recent piece in the Australian Financial Review: Bank hybrids riskier than they seem provides an excellent analysis on PERLS VII, the most recent major bank hybrid issued by CBA.

Also at the AFR, Jonathan Shapiro expresses the view that: “Commonwealth Bank of Australia is seizing on desperation among investors for income to raise $2 billion of hybrid capital at a historically low interest rate of around 5.45 per cent”. He goes on: “These new complex terms demanded by prudential regulators designed to increase the risk of hybrids have stirred controversy in investment markets”.

ASIC has also weighed in a number of times, and as early as August-2012 warned consumers of the risks and complexities of hybrid securities.

The banks are taking advantage of a “regulatory arbitrage”. In plain English, the banks get equity treatment for issuing hybrid capital but pay a fixed income return. Shareholders demand a return of 10-12%, so issuing shares is expensive and dilutive. Hybrid investors demand a return of just 5-6%, so issuing hybrids is cheap and benefits shareholders. Very few institutions are participating in new hybrid issues because they simply do not adequately compensate for risks.


Since July-2008 the Reserve Bank has cut rates from 7.25% to 2.50%, and they have plateaued at this level for over 12 months. It’s interesting to note that by developed world standards, Australia’s interest rates are high. They can go lower.

Naturally, term deposit rates have followed the overnight cash rate down. During the GFC banks paid attractive rates as they scrambled for retail deposit funding. Now that they are flush with funds, bank deposit margins are contracting and deposit rates are getting crushed. The shrinking returns experienced by term deposit investors look set to continue.


Like term deposits, bonds are legal debt obligations. They pay interest and they have a maturity date. Bonds have the added advantage that they trade, allowing investors to sell prior to maturity should they wish to realise some or all of their investment. Bonds provide a high degree of cash flow certainty and capital stability, and tend to out-perform in the event of a market correction. In fact many bonds actually rise in value when fear grips markets as interest rates fall and investors flock to quality.

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