Handle hybrid securities with care experts say

Published in the Herald Sun, February 2012 by Karina Barrymore

Is it a bird, is it a bull or is it a big white elephant? Actually, it's probably a cross-breed of all three.

Hybrid securities are rapidly coming back into fashion after their disastrous role in the global financial crisis.

But just like their name suggests, they're not really one thing or the other - they are not just a high-flying interest rate investment, not just a growth-style security, and not a total dud, but they can be a bit of all three.

Typically, hybrids are issued by large companies which need to borrow money.

They come with a promise to pay a set interest rate, such as four percentage points above the 90-day swap rate, which is regarded as the benchmark measurement of banks' funding costs.

But unlike most interest-rate investments, hybrids pay the interest on a regular basis, such as monthly or quarterly, and it arrives as a type of dividend including franking credits, which give investors an extra tax benefit.

They are also listed on the stock exchange and can be traded between investors at any time.

During the financial crisis, the demand for hybrids nose-dived and some investors found them difficult to sell.

Typically, the trading price does not vary much, but they can plunge in value if something disastrous happens to the company that issued them, the benchmark interest rate that they are linked to, or if there is a major financial crisis.

And while there are only four or five broad types of hybrids, each company that issues them can, more or less, set their own terms, interest rates, maturity dates or dates when they "convert" to shares.

Usually, no two hybrids are alike. Some convert to shares in the company that issued them, others pay back your initial investment amount, while others go on forever and, like shares, do not expire or have an end date.

Wealth Within analyst Dale Gillham says hybrids usually offer higher returns compared with other company debt investments, such as bonds.

And, unlike owning shares, investors know ahead what return they are going to get.

"Hybrid securities are considered a higher-risk investment, ranking up near equities for risk," Mr Gillham says.

"Given the increased risk, investors want increased returns, and this is why hybrid securities generally have higher interest or income payments."

On the downside, some companies in the past have suspended distribution payments to investors, while others slumped in value because interest rates fell.

Liquidity can also be a problem.

If an investor needs to sell and there is no one willing to buy, which was a problem during the financial crisis, then there is little ability to cash out of the deal.

"For investors looking for higher income streams, hybrids may form part of their overall investment, however, care should be taken as to which hybrid is used and that investors understand the risks," Mr Gillham says.

"Investors need to determine whether the higher return is enough to offset the extra risk taken.

As always, as with any investment, my advice is that investors should know what they are getting into but, more importantly, know how they can get out of the investment."

Australian Securities Exchange spokesman Asanth Sebastian says hybrids are a cross between a corporate bond and a share.

So they have the risk characteristics of both these investment types.

"It depends on the company and, as always, doing due diligence on the company that is issuing the hybrid, just the same as you would with a share."

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