Hybrid Securities: Debt Exposure For Equity Investors

Hybrid securities are a little known, unique feature of the Australian equities market. The product has three main types, but the most common, convertibles, offers exposure to bond-like instruments, with the convenience of the equity markets. Let’s dive in and find out how hybrid securities can help you diversify your portfolio.

The Three Musketeers

There are many types of hybrid securities, but you will generally see one of three main kinds: convertibles, preference shares and capital notes.

• Convertibles are a form of hybrid debt security that allows either the investor or issuer of the security to convert the hybrid security into a different security type (most likely equities) at a specific date. Don’t worry, all of this is clearly explained in the hybrid security’s description.
• Why would somebody buy a convertible, and how is it different from an option? The main difference is convertibles are a debt security that pays interest (like a bond). That’s right; convertibles are a way for you to get exposure to debt financing with the ease of equity trading.
• Preference shares usually, but don’t always pay a set dividend. Either way, unlike normal shares where the dividend is determined each quarter, preference shares have the dividend policy set out. Additionally, preference shares rank ahead of ordinary shares when a company distributes assets due to bankruptcy but still below debt holders. The downside is that these shares rarely have voting rights.
• Capital notes are debt securities with aspects of equity that generally fall into two subcategories. The first is perpetual debt securities. This form of debt has no fixed maturity date, and will pay a set interest rate forever.
• Subordinated debt securities is a secondary class of debt, which, as the name suggests, does not rank highly in the recovery order in the case of bankruptcy.

How Do They Trade

Like equities, hybrid securities are traded on Australian exchanges between cash trading hours and settle on a T+2 basis. The main difference between how equities and hybrid securities are traded is hybrids are usually classified with tickers between four and six characters.

Risks And Benefits

It is important to always read the details of what hybrid security you are buying; not all are the same. This is what is considered a complex instrument. Still, especially in a time of rising interest rates, it can grant investors exposure to a debt market that is finally starting to pay higher rates of interest. Below we have created a brief list that highlights some (but not all) of the risks and benefits associated with hybrid securities.

Benefits:

• Hybrid securities potentially yield higher interest income compared to bonds, savings accounts, and common stocks.
• Hybrid securities can grant a degree of diversification for an investor’s portfolio.
• Hybrid securities can be ahead of common stockholders in the case of bankruptcy.
• Hybrid securities will frequently experience lower volatility compared to common stocks.

Risks:

• Due to their equity like nature, hybrid securities will often have a higher risk profile when compared to bonds
• Hybrid securities are complex financial instruments and this creates difficulties in achieving effective pricing
• Hybrid securities are often traded far less than common stock, and this often will create liquidity risk
• Convertible hybrids securities can be called and converted to ordinary equity by the issuer

Most Actively Traded Hybrid Securities

*These are the top 5 most actively traded securities by value on the ASX for the month of July. Source: ASX Hybrids Monthly Report July 2022

How To Search And Understand Each Hybrid Security – Example NABPE

Hybrid securities that are listed on the ASX usually has a code between 4-5 characters long.

Let first break down the ASX code 

• NAB l The first 3 characters identify the issuer, for example NABPE is a hybrid security offered by National Bank of Australia and their ordinary stock code is NAB.
• P l The fourth character indicates the type,  P indicates that this is a preference share.
• E l The fifth character will indicate the number of that particular security within a series.

Hybrid securities also have either a short or long description, on Stake the short descriptions is displayed after the ASX code, for NABPE the description is NYM3QUT.

The below guide will help in breaking this down.

• N l Capital note Debt securities that give the issuer or a third party (such as a prudential regulator like APRA) a right to extinguish them under certain conditions.
• Y l Floating rate The interest rate payable on the security is a floating rate comprising a published reference rate and a fixed margin (which may be zero) set by the issuer.
• M l The security’s maturity date
• 3 l The security has a quarterly coupon payment.
• Q l The debt to security holders is subordinated to debts to unsecured creditors.
• U l The security is unsecured.
• T l The date on which a conversion, redemption, call or put can occur, whichever is first.