ASIC Warns of Hybrid Securities
Dequity Partners Dequity Blog
ASIC is starting a campaign to warn issuers and intermediaries to ensure that the risks involved in hybrid issues are made clear to retail investors. Currently, the big issuers of hybrids are the banks. There are other issuers but I’m sure that, if these fund raisings are successful, other lesser companies will jump on the band wagon, but more of that later.
Why this is an issue now?
Following the GFC and the upcoming introduction of new capital and liquidity requirements (Basel III), the banks are looking for ways to attract new capital. Because of low share prices, they prefer to issue debt so that their existing shareholders are not significantly diluted and, if possible, they would like to issue debt (interest is tax deductible) that can, in some cases, be treated as quasi equity or at least as Tier 1 capital.
Additionally, with the share market at a low point and investors being very cautious, debt is seen as a safer bet than equity and so banks are issuing the type of securities that many investors are happy to invest in.
What are hybrid securities?
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share.
Therefore, unlike a share of stock (equity) the holder has a ‘known’ cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares.
A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.
The important hybrid instruments are:
- Preference shares;
- Convertible/exchangeable debentures/bonds; and
- Debt with attached warrants.
There are five types of hybrids securities that have been issued by banks and other Australian companies which are currently available, which are outlined below.
Income Notes and Securities that have no maturity date or a very long maturity. These securities usually pay floating rate coupons and while the issuer normally has the option to redeem them for their face value on any payment date it is unlikely they will ever be redeemed.
Income Notes and Securities have been issued by Bendigo Bank (BENHB), Macquarie Group (MBLHB), National Australia Bank (NABHA) and Suncorp Metway (SUNHB).
Reset Preference Shares are typically fixed rate preference shares where the coupon is set for a defined term, normally five years. At the end of the five year period, the preference shares are marketed again when they are either redeemed or a new fixed coupon rate is set. They are technically perpetual securities.
Reset Preference Shares have been issued by Bendigo Bank RPS (BENPA), Bank of Queensland (BOQPA), IAG Reset Preference Shares 1 (IAGPA) and Suncorp Metway RPS (SUNPA).
Converting Preference Shares are preference shares that convert into the ordinary shares of the issuer after a defined period of time assuming certain conditions occur. Most converting preference shares offer the option for the issuer to redeem them for cash. However, conversion to equity is usually the default option. These are also technically perpetual securities.
Banks that have issued Converting Preference Share include ANZ (ANZPA & ANZPB), Westpac (WBCPA & WBCPB) and Commonwealth Bank PERLS 4 & 5 (CBAPB & CBAPA).
Step up Preference Shares are the most common type of corporate hybrid security. These preference shares normally pay a floating rate coupon and have a call date (the issuer can choose to redeem them) after a set period, normally five years. If these securities aren’t called at the first call date, then the coupons (interest payments) ‘step up’ to a higher rate to compensate investors for non-redemption. They are also technically perpetual securities.
Step up Preference Shares have been issued by Elders SPS (ELDPA), Fairfax SPS (FXJPB), Goodman Plus (GMPPA), Orica SPS (ORIPB) and Woolworth’s Notes (WOWHB).
Stepped up Preference Shares are step up preference shares that have already passed the step up date and pay a higher coupon over and above the original coupon. They are technically perpetual securities although the issuer has the option to call the securities on any future coupon (interest) payment date.
Stepped up Preference Share have been issued by the Australand Assets Trust (AAZPB) and Gunns Limited (GNSPA).
Most of the issuers to date are well regarded companies. However, if the market for these securities continues to develop, it is likely that the quality of the new issuers will fall.
What are the risks involved?
ASIC itself has produced a good description of the risks of hybrids which states that:
Hybrid securities have higher risks than most types of corporate bonds. While the conditions, timeframe, risks and interest rates of each hybrid offer differ, some have particularly complex features and risks:
Market price volatility – Like company shares, the market price of listed hybrid securities may fall below the price that the investor originally paid, especially if the company suspends or defers interest payments, or if its performance or prospects decline. Changes in the company’s share price and in other interest rates may also be reflected in the price of the hybrid listed security;
Subordinated ranking – Hybrid securities are generally unsecured, meaning that repayment is not secured by a mortgage or security over any asset. If the company issuing the hybrid securities becomes insolvent, hybrid investors generally rank behind senior bondholders and subordinated bondholders. If a company fails, hybrid investors have to line up behind these creditors and bondholders in the queue for their money;
Deferral of interest payments – Some offers allow the company to suspend interest payments for a number of years. While the interest owing may be cumulative (meaning it should be compounded and repaid to investors later), this could leave investors temporarily out of pocket. The security’s market price may fall due to the decision to hold back interest payments;
Early termination – Some hybrid offers allow the company to terminate or ‘buy back’ the investment early but do not give that same right to investors; and
Extremely long timeframes – Some hybrids have investment terms lasting several decades. For example, with a 60 year term, a 40 year-old investing today would need to live to 100 to see their investment mature. You may be able to sell the security on a secondary market such as the ASX, but only if there is a demand for that security. And the risk of a company defaulting on its obligations, or eventually running into financial difficulties, increases over the long-term.??Additionally, there is at least one other risk to consider which is that the quality of current issuers is quite high at the moment (mainly highly regulated banks). If the market continues to develop, the average quality of issuers may fall and the risk of default may become much higher especially given that most hybrid issues are usually the most subordinated level of debt and, generally, only have precedence over the equity of the company.
Issues for retail investors and conflicts of interest
Hybrid securities have many different forms and are quite difficult for even sophisticated investors to understand. For most retail investors they are not only very difficult to understand but they may be quite inappropriate investments for many of them.??The real worry is that many retail investors will encouraged to invest in these securities by financial advisers who:
- do not themselves fully understand these securities themselves;
- do not or cannot fully explain the nature and attendant risks of the securities to retail investors; and
- are driven by sales based commissions to sell these types of securities to retail investors for whom they may not be appropriate.
ASIC will do what it can to ensure that both the issuers and the product sellers ensure fully explain the risks involved in investing in these hybrid securities but, as always, there may well be an element of mis-selling. Given given the long maturities of these securities, this is not likely to manifest itself for a number of years.
Tags: ASIC, Australian Banks, Basel III, Convertible Notes, Debt, Debt & Equity, Debt with Attached Warrants, Equity, Fixed or Floating, GFC, Hybrid Securities, Preference Shares, Retail Investors, Risks
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