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Hybrid securities have tended to offer attractive franked income returns for usually only moderate levels of capital volatility. As such, and especially in these times of very low cash and fixed-income returns, they offer a potentially useful additional source of income and diversification in many investor portfolios.
Good potential yield for moderate volatility
As the name implies, ‘hybrids’ have both bond and equity features to varying degrees and sit somewhere between these two more traditional asset-class exposures on the risk-return investment spectrum.
Compared to equities, the income returns from hybrids are relatively more assured over time – but somewhat less so than that from cash and traditional bonds. Hybrid holders would also normally get paid out ahead of equity owners should the relevant company or bank be wound up, but not before traditional bond holders and depositors get their money back.
Indeed, the major distinguishing risk feature of hybrids, especially bank hybrids which account for the major component of the local market, is that they can be converted into ordinary shares – subjecting investors to the potential loss of capital – either as required by regulators or decided by the bank itself should it face financial difficulty. It’s for this reason that hybrids’ capital values can be sensitive to changes in corporate credit spreads over time.
That said, it helps that Australia’s major banks are among the financially soundest and most profitable in the world1. To date, no Australian major bank hybrid has ever been converted into equity by regulators, and no Australian major bank has deferred or cancelled a distribution/dividend payment. In a sense, investing in major bank hybrids effectively involves accepting the (arguably low) ‘tail risk’ of a major Australian bank getting into significant financial difficulty. But to the extent this is considered a serious concern, an investor might ponder their existing exposure to bank shares, and the broader Australian equity market.
Hybrids offer less risk in other respects. Being largely floating-rate in nature2, hybrids largely avoid the interest rate duration risk associated with fixed-rate bonds whereby the latter’s price or capital value is inversely correlated with the changes in the general level of market interest rates over time. This is particularly noteworthy in the present climate (at the time of writing), given interest rates globally remain quite low but are generally forecast to start rising over the next few years.
A seen in the chart below, the unique set of risks associated with hybrids has meant the yield available on major bank hybrid securities (which constitute the major component of the hybrids market) has generally been somewhere between that of Australian fixed-rate bonds and bank dividend yields over time.
Historical Income or Yield Comparisons
Sources: Bloomberg, Coolabah Capital. Bank dividend yield is the gross trailing dividend on the S&P/ASX 200 Banking Index. Bond yield is the yield-to-maturity on the Bloomberg AusBond Composite Bond Index. Bank hybrid yield is the estimate average gross yield-to-call as compiled by Coolabah Capital. You cannot invest in an index. Past performance is not indicative of future performance.
As at 31 March 2021, the running yield (including franking credits) of the index BHYB aims to track was around 3.5% p.a., as shown in the chart below. Since its inception in February 2012 to 31 March 2021, the index which BHYB aims to track generated a total return of 4.1% p.a. (net of franking credits) and 5.8% p.a. (inclusive of franking credits)3.
Indicative Income Comparisons: 31 March 20214
Source: Bloomberg. As at 31 March 2021. Not all investors will be able to obtain the full value of franking credits. Index performance does not take into account any ETF fees and costs. You cannot invest directly in an index. Yields are indicative only, will vary over time, and may be materially different at the time of investment. Past performance is not indicative of future performance any index or ETF.
At the same time, as evident in the chart below, hybrids have tended to experience downside volatility somewhat greater than traditional bonds but considerably less than that of equities – especially since the unprecedented global financial crisis a decade ago.
Historic Drawdown Curve
Source: Bloomberg. Past performance is not indicative of future performance of any index or ETF. You cannot invest directly in an index. Index performance does not take into account ETF fees and costs. For Australian Bank Hybrids data, a spliced index series is used, incorporating Evans & Partners All Bonds & Hybrids ASX Index prior to February 2012, and the Solactive Australian Banking Preferred Shares Index from February 2012.
The BetaShares Australian Major Bank Hybrids Index ETF (ASX Code: BYHB)
Thanks to the advent of exchange traded products, the good news for investors is that it has never been easier to invest in a diversified portfolio of hybrids on the ASX.
Since November 2017, the BetaShares Active Australian Hybrids Fund (managed fund) (ASX Code: HBRD) has offered an actively managed exposure to these securities. HBRD is actively invested across cash, hybrids and other short-duration debt instruments and aims to deliver total returns that exceed the benchmark Solactive Australian Hybrid Securities Index over time.
So as to expand the choices available to investors, the recently launched the BetaShares Australian Major Bank Hybrids Index ETF (ASX Code: BHYB) provides lower cost, purely passive exposure to a portfolio of hybrids issued by the Big 4 Australian banks5.
There are risks associated with an investment in BHYB and HBRD, including dividend rate risk (for BHYB), interest rate risk (for HBRD), credit risk, hybrids complexity risk and sector concentration risk. For more information on risks and other features of each fund, please see the Product Disclosure Statement, available at www.betashares.com.au.
1. As noted by the Reserve Bank of Australia in its October 2020 Financial Stability Review, “on an internationally comparable basis, the four major banks’ Common Equity Tier 1 (CET1) capital ratios are estimated to be well within the top quartile of global banks and at a level that has historically been sufficient to withstand almost all previous bank crises”. At the same time, the RBA noted “Australian banks’ profitability continues to be above that of banks in most other comparable economies”.
2. Specifically, their quarterly interest payment is based on the prevailing market-determined interest rate at which banks agree to lend each other funds over the following 30-day time period (known as the 30-day bank bill swap rate, or BBSW). In addition, hybrids pay a fixed interest-rate margin over BBSW that is fixed at the date of hybrid issue and reflects the hybrid’s series of callable dates and the prevailing market assessed credit risk associated with each bank.
3. Source: Bloomberg. Index performance does not take into account any fund fees and costs. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or fund.
4. ‘S&P/ASX 200 Banks Index’ represents estimated (forward) dividend yield based on consensus analyst estimates. ‘Running yield’ is the anticipated income payments plus any franking credits expressed as a percentage of the current market value of the securities. ‘Yield to call’ is anticipated income payments and any prospective capital gain or loss that would arise if each hybrid security was redeemed by the issuer at its par value at the next scheduled call date. ‘Yield to maturity’ takes into account the anticipated income you receive, and the difference between the current market price of the securities and the face value to be repaid at maturity. BHYB’s Index is the Solactive Australian Bank Preferred Shares Index.
5. For more detail regarding index construction, please see the Product Disclosure Statement (PDS), available at www.betashares.com.au.