For a little over a year SIRA Group has been running an Income Portfolio designed to maximise the income and earnings to the investor whilst offering much lower volatility in the price. This portfolio invests in a variety of areas including preference shares, subordinated and/or convertible notes, corporate and government bonds and other traditional fixed income securities.
Over the last few months there has been some discussion in the financial press about the risks of these investments and how some investors who have purchased these securities unwittingly believing them to be risk free, are leaving
themselves open to unexpected losses. Given this we feel it is important to provide a discussion on these types of investments to reassure our clients that any risk a private investor might be exposed to is reduced significantly in a portfolio managed by professional investors.
So, what is a hybrid?
As the RBA cash rate has fallen, the question of investment yield has become more important. Where once it was easy to hold your investment capital in cash while still getting an acceptable income return, this is no longer feasible.
The cash rate has fallen to 3.25%, and expectations are that it will fall further. Dr Shane Oliver of AMP Capital, one of the more competent top-down financial analysts in Australia, predicts that the cash rate will reach a low of 2.5% by March next year.
Ordinary shares offer a tempting alternative—but with a potential offset. The average dividend yield on the All Ordinaries index is about 4.5%, but that is before adding back franking credits. Including franking credits, the effective
yield is close to 6%, with the strong likelihood of capital gains over the longer term. In the short run though, global and local economic and financial conditions have made the share market volatile, not just at the overall (average) index level, but also within sub sectors. Under these circumstances, many investors are uncomfortable with ordinary shares.
So the issue arises: how is an investor to achieve higher yields than are obtainable in cash without exposing the investment portfolio to substantial volatility? The (partial) answer is hybrids (the other is to diversify across other asset classes that are not correlated).
Hybrids are shares or share-type instruments which have the characteristics of other higher yield instruments like bonds but which have much lower risk and volatility than ordinary shares. Preference shares, for example, typically pay a dividend just like ordinary shares but the dividend is fixed, so that even if the dividend on the company’s ordinary shares is cut or passed, the ‘prefs’ still pay theirs. Many preference shares don’t pay a fixed dividend but instead pay a fixed percentage above the RBA cash rate. Depending on the tax structure, there are also “notes” which do the same thing. These tend also to be called hybrids, though they are in fact technically debt instruments not shares. Recent note issues have featured a yield 4.5 or 5% above the cash rate. This means that even when the cash rate falls, they will still offer much better returns than cash or fixed deposits. For example, if cash rates fell to 2%, they would still pay 6.5 or 7%.
Hybrids often deduct company tax before the dividend is declared so that the yield appears to be low; but the investor then claims back the related tax credit when he or she receives the dividend. For this reason, yields on hybrids and notes are usually analysed on a cum-tax basis, i.e., adding back franking credits where applicable.
For the sake of completeness, though they are not strictly speaking “hybrids”, we should also mention corporate bonds. These typically have a fixed coupon (interest payment), which means that when interest rates fall they rise in price and when interest rates rise they fall in price. In that sense, therefore, their returns are more volatile than hybrids or notes where the yield is a fixed amount above the cash rate – unless they are held to maturity.
Obviously, the higher yield from these investments comes at the cost of higher risk.
There are two separate (but related) risks with hybrids/bonds/notes. The first is non-payment or suspension of dividends/coupon payments, the second is loss of capital.
Most of the hybrids/notes/bonds we invest in have clauses in their covenants which state that if their income payments are suspended or stopped, dividend payments on that company’s ordinary shares must also be suspended. With the major companies we invest in, this would be a humiliation to management and would be likely to occur only in the gravest crisis. During a crisis of the magnitude of the GFC, some hybrids/bonds/notes would pass their dividends or suspend their coupon payments. But we would sell before such a crisis, and switch portfolios to cash.
The other risk is that capital is not returned. This risk is much smaller than with ordinary shares, except during a major melt-down. This risk applies to all noncash investments and can only be controlled by constant monitoring of the investment and economic outlook, which we do. In the case of small individual investors in hybrids/bonds/notes who “set and forget”, risk is higher, perhaps a lot higher, than it would be for professional investors who monitor portfolios
frequently.
SIRA Group controls the risk in hybrids in several ways:
Return is always correlated with risk: the higher the risk, the higher the return. The key variables in managing this trade-off are insight and monitoring. Risk is much more dangerous if you don’t know what you are doing. For example, crossing the road is risky, but adults manage. Toddlers, however, do not. That is because adults have greater insight and monitor the risks more carefully than toddlers do. Though the risk remains, it is much reduced.
So yes, there is some risk in hybrids/bonds/notes, but SIRA Group watches these risks diligently and carefully and monitors portfolios frequently.
What about alternatives to hybrids?
There are two, at different ends of the risk spectrum.
The first is government bonds. Unfortunately, government bond yields are now extremely low—with 5 year Commonwealth bonds yielding around 2.5% and 10 year bonds around 3%. Moreover, since the coupons are fixed, if general interest rates rise the prices of the bonds will fall. Of course, conversely, if the general interest rate level declines, prices will rise. But because yields are so low by historical standards and have been driven to extremes by Central Bank buying of bonds to encourage growth via quantitative easing, there is a serious medium term risk if growth does recover. If that happens (and it seems very likely that either growth or inflation or both will rise) bond yields will rise back to more normal levels, which would create significant capital losses. We have not ruled out bonds entirely—if we foresaw renewed economic downturn, we would shift some of the hybrid/yield portfolios into bonds—but at present we see no point in holding them.
The second is ordinary shares. Consider: a fixed deposit with a bank would yield around 4.7% at present, a bank hybrid (after adjusting for franking credits) 7-9%, and bank shares (also after adding back franking credits) 8-11%. You might well ask why you would invest in the bank hybrid when you can obtain a higher yield and the possibility of capital gains in the bank’s ordinary shares. The answer is that though the returns from the ordinary shares are likely to exceed the returns from hybrids in the longer term, this comes at the cost of higher volatility. This additional volatility is unacceptable to some investors.
What percentage of hybrids you should in fact have in your overall portfolio depends on several factors: your income; your age; your risk averseness; and your other investments.
As always, if you feel you would like to discuss your financial affairs and your investment portfolios with us, including weightings towards hybrids, shares, property, cash or international exposure, please do not hesitate to contact us.
