Hybrid security funds may be suited to investors looking to receive tax-efficient income greater than the income typically generated by traditional bank term deposits, cash or regular bonds.
What are hybrid securities?
Hybrid securities have features of both equity and debt.
Different hybrids have different features, which can make it tricky for investors to compare the various hybrid securities. Investors need to read the terms and conditions of each hybrid security in order to properly understand its benefits and be able to assess its fair value.
As a result, investing directly in a hybrid security on the Australian Securities Exchange (ASX) may prove challenging for investors who lack the expertise or time to evaluate whether the hybrid suits their investment objectives.
A hybrid security fund such as the BetaShares Active Australian Hybrids Fund (managed fund) (ASX: HBRD) is a convenient alternative to direct ownership of hybrid securities.
HBRD aims to deliver returns that exceed the ASX hybrid securities market over time.
How do hybrid securities work?
Hybrid securities typically pay a fixed or floating rate of return until a certain date.
Hybrid securities are generally expected to provide a higher rate of return than regular debt securities such as bonds. However, because of their equity features, hybrid securities are considered to be riskier than bonds and because they rank higher in a company’s capital structure, they are typically considered less risky than equities.
Types of hybrid securities
There’s a wide variety of hybrid securities that can be bought on the ASX.
Some hybrid securities may pay franked income like ordinary shares, while other hybrid securities also have an option to convert to shares. Other hybrids will convert automatically into shares if certain events happen or on certain dates.
Hybrid securities examples
Hybrid securities can be classified into broad categories:
- Preference shares – Preference shares are equity securities that pay debt-like returns.
Usually, preference shares carry a specified dividend rate, either fixed or floating. This is unlike ordinary shares, which pay a variable rate as determined by a company’s directors.
A preference share is given the name because it is a share which entitles holders to priority over dividend payments to ordinary shareholders.
- Capital notes – Capital notes are debt securities with some features that are similar to equities. Here are some examples:
Perpetual debt securities are debt securities that have no fixed maturity date (like shares).
Subordinated debt securities are debt securities that have interest and principal repayments that rank behind another class or classes of debt, for example, holders of senior debt or ordinary creditors generally.
Knock-out debt securities give the issuer (typically banks or other prudentially-regulated companies) or a third party such as the Australian Prudential Regulation Authority (APRA) the right to write them off completely under particular conditions (e.g. if the underlying asset’s price falls below or exceeds a set price). They are a debt security with share-like features, such as no right to a return of capital.
- Convertible notes and bonds – A convertible bond resembles an ordinary bond, but its price rises and falls typically by reference to the issuing company’s shares. A convertible bond generally offers greater potential for appreciation than a regular bond, but it also pays less interest and is subject to the risk that the issuer may default on coupon payments or on paying the principal of maturity.
How actively managed hybrid security funds work
Given the complexities of investing directly in hybrid securities traded on the ASX, a fund that offers exposure to a diversified portfolio of hybrids offers an attractive alternative.
The BetaShares Active Australian Hybrids Fund (managed fund) (ASX: HBRD) invests in an actively managed portfolio of hybrid securities, bonds and cash.
It can make sense for many investors to gain access to the unique risk and return features of hybrids through a professionally run, actively managed fund, as this provides not only diversification and risk management benefits, but better buying power and expertise to take advantage of market mispricing opportunities over time.
Retail investors are reliant on making trades through the exchange, however, professional fund managers can additionally source other hybrids opportunities – and often deeper liquidity – through direct trades with other financial institutions in over-the-counter (“OTC”) transactions.
For regular investor manager commentary and more information on hybrid security funds, click here.
What happens to hybrid investments if the sharemarket drops?
Hybrids are unique in that that they have both bond and equity features and, as such, provide a unique diversification opportunity to investors along the risk-return investment spectrum.
While hybrids do have the possibility of incurring a capital loss, they historically have shown to be less volatile and relatively less risky than equities.
Hybrids also generally offer a greater prospects of regular income payments and repayment of capital at a future date. They also offer franking credits like shares, which are not available via bond and cash investments.
Why is preferred stock (or preference shares) referred to as a hybrid security?
Preferred stock (or preference shares) are often referred to as hybrid securities because they combine characteristics of both ordinary shares and the debt represented by bonds.
Some companies issue preference shares as well as ordinary shares of the company.
A preference share is an equity security with a specified dividend rate set out in the prospectus. Also, preference shares are usually non-voting, unlike ordinary shares.
Each preference share represents an ownership share in the issuing company and is not a debt that has to be repaid, unlike a bond.
Preference shares pay a specified dividend rate, which is typically higher than ordinary share dividends and can perform favourably compared to bond interest rates.
This is why an investor looking to generate income may consider using preference shares as an alternative to bonds.
What are the advantages of investing in a hybrid security fund?
Some of the key benefits of the BetaShares Active Australian Hybrids Fund (managed fund) (ASX: HBRD) include the following:
- Professionally managed hybrids exposure – Actively managed fund helps investors gain exposure to a diversified portfolio of hybrids and aims to reduce potential downside risk associated with owning hybrids directly
- Lower volatility – The fund targets volatility of 3% to 4% p.a. – less than one-third of that historically displayed by the Australian equities market
- Risk management – The investment manager is able to increase exposure to cash and bonds if required given market conditions in order to reduce risk
- Potential for outperformance – Actively managed portfolio aims to deliver total returns that exceed the ASX hybrids market over time
- Regular, attractive tax-efficient income – Monthly franked income expected to be in excess of that available from cash and senior bonds
- Position for rising rates – The fund’s income should be expected to rise should interest rates rise and vice versa
- Portfolio diversification – Hybrids have historically exhibited low correlation to equities as well as generally shown defensive characteristics during sharemarket declines
- Liquidity – May benefit from access to superior liquidity compared to directly held hybrids – the fund trades on the ASX like any share
Investment risks in relation to the BetaShares Active Australian Hybrids Fund (managed fund) (ASX: HBRD) include interest rate risk, credit risk, liquidity risk, hybrids complexity risk and sector concentration risk. For more information on risks and other features of the fund, please see the Product Disclosure Statement, available at www.betashares.com.au.