Australian investors are on the hunt for yield. That was the message loud and clear in the first quarter of 2012 as almost $5 billion in corporate debt and hybrid securities was lapped up by investors looking to put their cash mountains to work.
While companies such as AGL Energy, Colonial and Tabcorp have been able to take advantage of investors’ desire for income securities to meet their capital needs, Australian fixed income fund managers haven’t experienced similar levels of enthusiasm for their offerings.
A hybrid is not defensive
Bond fund managers and regulators have gone to great lengths to point out that hybrid securities should not be categorised by investors as defensive and are not a substitute for cash, government bonds or even high-grade corporate debt.
“To the extent that investors are looking towards fixed income to provide them with insurance and protection when their growth assets such as equities are falling, then hybrids haven’t been able to do that,” Aberdeen Asset Management’s head of fixed income, Victor Rodriguez says.
Hybrid securities such as those issued recently by Insurance Australia Group and Westpac are a mixture of debt and equity and therefore carry some equity-like risks, while subordinated debt securities, such as those issued by Tabcorp, Colonial, AGL Energy and Australia and New Zealand Banking Group may never convert to shares. But they are regarded as equity by credit rating agencies because, under severely stressed situations, they will provide support.
Government bonds and hybrids are distant cousins and behave very differently in stressed market conditions.
A hybrid security’s value is more aligned to that company’s stock as its ability to generate revenue to meet its obligations influences the probability that hybrid distributions will be met and capital returned.
“You tend to get negative returns [from hybrids] when equities are falling because they are deeply subordinated and have a historically high correlation,” Rodriguez says.
In terms of fixed-income securities, hybrids are more comparable with corporate bonds and other credit securities.
“Credit” is the riskier subset of fixed income and relates to the reward or margin (in the form of extra interest above a benchmark rate) earned from betting against the default of a company. The higher the risk of default of the company, the higher the compensating return.
Specific terms and seniority of a particular security also affect the appropriate return. For instance, senior debt investors in a particular company will accept lower margins than subordinated debt or hybrid investors who have fewer rights and lower-ranking claims on the company’s asset because their investment is safer.
Further, interest payments to senior debt holders must be made, while subordinated note and hybrid investors can find that their distributions can be cut or delayed in adverse circumstances.
Investors might still find that, despite the non-defensive nature of hybrids, they’re comfortable with the risks and the returns.
Understand the risks
But investors need to be mindful of the nature of credit investing, where you earn a modest return if the company stays solvent but are subject to heavy capital losses if it doesn’t. Spreading default risk by diversifying is essential.
“Investors seeking more yield will need more diversification,” Rodriguez says. “But the more yield you seek through credit, the more you give up the defensive insurance property of bonds.”
Fund managers argue there are other ways to earn similar returns versus investing directly in hybrids, which results in concentrating the risk of default among a small set of companies.
“Increasing the amount of individual holdings within a credit portfolio is one of the most effective ways to reduce the risk of a credit portfolio,” Bentham Asset Management director, Richard Quin, says.
He points to studies that suggest credit portfolios should hold four times as many securities as an equity portfolio. Assuming that an equity portfolio is appropriately diversified with 40 exposures, a credit portfolio would require 160 exposures.
Bentham’s Global Income Fund, for example, has 616 individual company exposures and pays an equivalent annual coupon rate of about 8 per cent on a monthly basis.
“The Australian hybrids market offers only about 30 issuers with 50 securities, which provides investors with very limited ability to diversify to reduce their risk, before even considering the investment merit of each security,” Quin says.
The low-ranking nature of hybrids in the capital structure means diversification is even more critical. “Investing in preference shares and subordinated debt means that you need more diversity because unexpected losses on any individual security can be much greater,” he says.
Rodriguez says that in a share portfolio the winners can make up for the losers but, in fixed income, the outcomes are slanted towards whether you get your money back or not.
“If you have one defaulting bond, then the other five bonds in the portfolio aren’t going to save you because they aren’t going to double in price,” he says.
“The skewed nature means you need more diversification than the Australian market can provide in a pure credit portfolio.”
Hybrids have had a mixed press of late for supposedly being riskier and more so than perceived, but some believe that the returns are sufficiently attractive. “The fundamental issue is that the structures are biased towards the issuer and you are effectively selling put options,” portfolio manager for hybrid fund Elstree, Campbell Dawson, says.
“They’re halfway between debt and equity. The point is: are you getting paid enough to take those risks in a diversified portfolio? And the answer is, I think you are. The margins would be equivalent to what the long-term equity return is, in terms of risk premiums,” he says.