Sharp step-ups in interest rates have upset equities and bond markets, eroding the present values of future dividends and coupons. The $45 billion middle ground – the listed hybrid securities of banks and corporates, where regular income is adjusted with movements in the cash rate – has managed volatility in its own elastic way.
There often appears to be value hiding among the list of hybrids. The floating interest rates on hybrids benefit from a rising rate environment, said BondAdviser’s John Likos in May. But as a result, these dynamic investments are nowhere near as predictable as bonds – although it’s easy to think of them that way.
To complicate matters, ratings scores for hybrids from the likes of Standard & Poor’s or Moody’s aren’t shared with retail investors in Australia. Instead, they must make judgements based on metrics reported in resources such as Morningstar’s research page on hybrids, where price and income for each issue are embedded alongside data on trading margin, running yield and yield to maturity.
For those investors looking at the asset class, Nicholas Chaplin, director and lead portfolio manager at BA Asset Management, explains what it all means.
Yield to maturity
This metric is a first starting point for assessing hybrids. It is the price gain (or loss) plus all income an investor who holds to maturity (or call date) can expect, expressed as expected annualised return.
“Yield to maturity includes some expectation of where rates are going,” Chaplin says. “That’s not fact – that’s expectation.”
Although yield to maturity is a useful measure, Chaplin says running yield is perhaps a better guide as it is based on today’s rates. Running yield is the expected return given market prices, or, more formally, the margin investors expect to receive for holding the security plus the benchmark rate, usually the 90-day bank bill swap rate (BBSW). Running yield will change in line with the price of hybrids and/or BBSW.
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With BBSW the same for every issuer, trading margin is a quick way to gauge the market’s assessment of an issuer’s credit-worthiness. If buyers like a $100 hybrid security and bid its price up to, say, $105, the trading margin will fall to reflect the fact that buyers who pay $105 will only be repaid $100. If the price of an issue falls below par value ($100), its trading margin will rise.
“It’s the effective margin you are receiving considering the last traded price,” Chaplin says. “The trading margin is a good way to compare issues – but you still must be aware of the credit.”
Looking at data on July 14, for example, Latitude Capital Notes (LFSPA) had a trading margin of 7.05% compared with 3.63% for Macquarie Bank Capital Notes 3 (MBLPD). As far as the market is concerned, Macquarie is a better credit. An investor who has a positive outlook for Latitude will go counter to the market and grab that 7.05%.
Not quite the safety of bonds
The history of corporate hybrids includes some failures. “Corporate issuers may have less reliability compared with a bank or insurer because they don’t have that oversight of the prudential regulator,” Chaplin says. The decision to invest in a corporate hybrid, he says, is akin to holding its shares – noting that a hybrid is higher on the capital structure, so there’s more chance of being paid out if collapses.
Even though many of the 45 hybrids listed on the ASX are issued by ASX20 companies and are paying fat returns compared with term deposits, they do not qualify as defensive assets. APRA has the power to step in and tell any big bank issuer that it cannot payout an issue, although Chaplin hasn’t seen it happen. Also, quarterly or semi-annual payments are made at the issuer’s discretion.
“That’s why a little bit of reading of the prospectus is a good idea, even if you’re buying secondary [on the exchange],” Chaplin says.
His checklist for hybrids is: consider brands you like and then look at the issue margin, yield to call (yield to maturity) and trading margin. Another thing – be careful about buying in the price dip just before a payment, because there are often enough buyers attracted to those short slumps to push prices above where they should be.
In case you’re wondering who are the professional traders on the other side of such arbitrage opportunities, Chaplin runs the Bond Adviser Financial Capital Income Fund, targeting the cash rate plus 3%.