Sep 11

Should access to Bank Hybrids be restricted?

Hybrids issued by financial institutions have been back in the news recently, for two conflicting reasons.

On the one hand, we have seen a flurry of new offers in the market, with CBA, Challenger and Bendigo all issuing new hybrid stock. The market’s response to these has been enthusiastic, to say the least, with all of the offers closing early and oversubscribed, as investors hunt for yield.

On the other hand there have been calls for restricting retail investor access to these new issues on the back of a move by UK regulators to restrict retail access to the structurally similar “CoCos” in that market.

Hybrids clearly have plenty of appeal to investors in a low interest environment. The key question is whether retail investors are reasonably likely to be able to fully understand the risks associated with hybrids, and whether this assessment is significantly more complex or difficult than assessing the risks associated with an investment in ordinary shares in the same company. Each in turn requires understanding the overarching risk associated with an investment in a company, as well as matters such the company’s dividend policy and outlook, liquidity, and volatility.

The starting point is that bank hybrids which include the APRA mandated “loss absorption” features are, at the end of the day, an equity instrument. This means that the risk of investing in the hybrid converges with the risk of investing in the ordinary stock if there is a significant loss in value of the ordinary stock, triggering a conversion of the hybrid to ordinary equity. However the structure of the hybrid is such that they are likely to have less price volatility and a more predictable dividend flow than the fully paid ordinary. They will also have lower liquidity (because the total market value of hybrid shares on issue will be less than the total market value of ordinary shares), and an asymmetry of risk and reward- where the face value of the hybrid can fall to zero, it will not increase significantly above its issue price.

Thus an investor first has to ask themselves if they are comfortable investing in the company- a task common to either a hybrid or an ordinary share investment. With respect to dividend flow, it is quite difficult for the retail investor to assess risks to a company’s future ordinary dividends, making the relative stability of income a key appeal of hybrids. Given this, the retail investor should pay particular attention to the dividend commitments associated with the hybrid- for example, the presence of a “dividend stopper”, whereby a bank is not able to continue to pay ordinary dividends if it fails to pay the hybrid dividend. This provides strong protection given the importance of dividends to a bank’s share price and its ability to raise equity capital.

The likelihood that the market price of the hybrid will be less volatile than that of the ordinaries provides an additional measure of comfort for very conservative investors. Adverse news flow or a decline in the price of the ordinary shares may provide the investor with a trigger to sell out of the hybrid stock well before the market price of the hybrid has been significantly eroded.

Investors also need to weigh up the benefits of lower price volatility against the lower liquidity of hybrids, however volatility and liquidity are concepts common to ordinary share investments.

In summary, the key elements of assessing whether to buy a hybrid are not markedly different or necessarily more complex than assessing whether to buy or sell the ordinary shares of a company. The threshold issue is to frame it as an equity investment question- “am I comfortable investing in this company?” The key trade-off is then between the reduced volatility and relative dividend certainty of the hybrid against the scope for capital gain of the ordinary. In this context there does not seem to be a compelling reason to restrict retail investor access to hybrids, provided they are seen for what they are- a form of equity investment.

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