Hybrids - wolves in sheeps' clothing?

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In ancient times, the mythological hybrid was a creature combining the body parts of two or more species. Now the financial product bearing this name is also a beast of varied parts. Some important hybrid instruments are preference shares, convertible/exchangeable debentures/bonds and debt with attached warrants.

From an issuer perspective, hybrid securities may allow the issuer to raise capital while achieving a particular accounting, tax, credit rating or regulatory capital outcome. Following reduced activity during and immediately after the GFC, hybrid securities have recently been used for significant capital raising by both banks and well-known corporate entities.

Did you know there has been more than $18 billion of hybrids issued by banks and companies in Australia since November 2011?  There were approximately 75,000 investors in hybrid securities last year, two thirds of whom were self-managed superannuation funds (SMSFs).  

Hybrid securities often promise ‘high yields’ and are issued by well-known companies with trusted brands, but investors need to very carefully consider the features and risks before investing. Some hybrid securities make investors take on 'equity-like' risks but only give them at best, 'bond-like' returns. Some also have terms and conditions that allow the issuer to exit the deal or suspend interest payments when they choose. Some are very long-term investments (for example, more than 20 years).

ASIC is concerned about the marketing and promotion of these products. It released a report on 20 August 2013 dealing with this issue.  Why?

The issues are:

• inappropriate labelling of hybrids and unwarranted comparison of hybrids to different, less risky products eg covered bonds or senior debt
• advisers spruiking potential higher returns and using the brand name or reputation of the issuer without identifying the higher risks attached to that specific product
• investor education - do you know what a hybrid is and how it works?  Can you assess its risk profile?

Terms and conditions of each hybrid issue vary and in some cases they include features that mean they rank closer to equity than debt. Many involve heightened risks for retail investors, such as risks deriving from long maturities and more complex features such as interest deferral or potential conversion into ordinary shares. 

The overall complexity of hybrid securities makes clear, concise and effective disclosure to investors in a prospectus more difficult. 

All investors including SMSF trustees have a duty to understand their investments and ASIC has said it expects issuers, brokers and advisers to take particular care to promote clear communication to investors about the nature of an investment in these securities.  

You can download the ASIC report here: REP 365 or read more about hybrids on ASIC's moneysmart website here.  Call Sage Advisers if you have any questions about hybrids.

Opportunities from QE3?

Chairman Bernanke and the FOMC have acted strongly in their announcement of “QE3” overnight.  An immediate share market rally is expected by many, some argue that it’s been already priced in.  A complex web of domestic and international influences should be considered by Australians in making their investment decisions.

Commentators vary in their response to the Fed’s announcement ranging from Goldman Sachs’ view that “further stimulus represents a clear signal that economic growth remains stalled” to UBS’ strategic view essentially ignoring QE3 and taking steps to position for a pullback in stock prices post-easing and as the fiscal cliff approaches toward the end of the year.

Karen Maley writing in the AFR said today:

Critics argue that QE3 will undoubtedly affect the prices of assets, such as shares and commodities, but will have no effect on US employment. The Fed is able to affect asset prices because when it buys US Treasuries and mortgage-backed securities, it effectively removes these assets from the market. That pushes up the price (and reduces the yield) on those ‘safe haven’ assets. (Incidentally, it also pushes up the price, and reduces the yield of other ‘safe haven’ assets, such as Australian government bonds, which boast a triple-A rating.)

But QE3 won’t encourage businesses to borrow more money to invest and hire new workers, because companies are worried about feeble demand for their products. And QE3 won’t encourage consumers to spend more, because they’re worried about their job prospects, and banks remain extremely reluctant to lend to debt-laden households.  By pushing up their cost of living, QE undermines the living standards for millions of low- and middle-income households. The wealthy – who own large share portfolios – get a benefit from rising equity markets, but most people end up worse off financially.

By targeting mortgage bonds in his latest round of QE3, Bernanke is clearly trying to spread the benefits of QE3 to the US middle classes – for whom their house is their important asset. But with an estimated one in seven US households underwater on their mortgages, and with a mountain of foreclosed houses yet to hit the market, it’s unlikely that a marginal reduction in US mortgage rates will provide much of a boost to home prices, or spur activity in the embattled housing sector.

Back in March 2012 we wrote about Investing in a QE World.  In that piece we explained what QE is and how it has been implemented by the major central banks.  Since that time we have observed the European ECB and Bank of England response.

The Economics editor of the Guardian reflected on 6 September 2012:

In one important respect, QE did the trick, because without it there is no telling what would have happened to the global economy in the winter of 2008-09. By the summer of 2009 there was clear evidence that the decline in output had bottomed out. Fears of a Great Depression 2 were scotched.

And yet, QE was supposed to be a temporary measure, with the process reversed once the global economy returned to normal. Far from that happening, central banks kept on buying bonds. The Bank of England is on its fourth round of QE; the Fed is about to embark on its third. Despite an unprecedented stimulus, the global economy is losing momentum

Is it all bad, though? Before answering this question, Australian investors need to consider the following six interlinked areas:-

1. The Australian dollar:  Our earlier post set out the critical issues for our dollar including commodity prices and demand from foreign sovereigns.  Devaluation of the US Dollar inflates the value of ours – this correlation must be watched closely mindful of the negative effects on Australian producers & exporters of a high dollar.
2. Commodities prices: (especially iron ore) but also metals including gold and silver – to a very large extent these are determined by demand for our commodities from China.   Slowing global demand for our commodities particularly iron ore and other mining exports will be the greatest influence on our domestic economy for the near future.  The recent price falls in the iron ore price and its partial recovery will be pivotal.   The speed with which change in this sector can occur is exemplified by Fortescue  this week which is now in a trading halt as the company approaches its banks to waive lending conditions.  Watch this space – China is key.
3. Shares: There will undoubtedly be winners in equity markets in Australia and overseas.  The challenge is in picking suitable stocks (or ETFs) which sit happily with your risk profile and your proposed holding time.  We all know a trade is different from an investment.  Our summary of the current position is: Expect market volatility between now and the start of 2013 as global issues dominate including further chapters in the European debt crisis, Arab political instability, US presidential elections and dealing with the “fiscal cliff”. Traders may wish to consider income producing stocks including global ETFs. Traders may wish to consider diversification into natural resources funds as a potential hedge against future inflation (see more on inflation below).  Longer term investors may prefer to remain prudent in the face of continued volatility  and uncertainty and stay out of stocks until the start of 2013.   US equities may appear more attractive than Australian shares if you can manage the currency issues.
4. Inflation:  How do you protect your investments against this?  Protecting yourself against future inflation is going to be an increasingly important consideration now.  There are a number of options to consider – ranging from investments in gold, hedged equities, commodities, inflation protected bonds and ETFs.   We consider these options at length and propose specific strategies suited to our clients’ investment profiles and needs.  This is a sophisticated and complex area and we do not make any general recommendations at this point in time.
5. House prices: Australian house prices continue to be considered overpriced by international and historical standards.  Overseas commentators remain negative about future capital growth in the Australian real estate sector.  Domestically, there are mixed messages coming from different markets across the country.  However, the overall trend is that things are tracking sideways, with risks to the downside.  This is no environment in which to recommend investment properties with enthusiasm.  Yet we continue to receive multiple calls weekly from property spruikers wanting to put our self funded retirees into residential real estate investments.  We are currently resisting this trend and do not recommend Australian residential investment to our SMSF clients generally at this time.   We mention house prices now as we are going into a new spring selling season, mindful that supply of housing stock is at record highs, the time it takes to sell a house is also very long in Melbourne and Sydney and the recent volume of mortgage transfers reported by government is at historic lows.  We would not be surprised to see a flat or negative selling season ahead.  This has an effect on the Australian banking sector and bank stocks in particular given the huge focus they have had on domestic mortgage lending over the past decade.  Their massive profitability has ridden the “house price increase” wave and all commentators seem to agree that this ride is over: see Gail Kelly’s recent comments here.
6. Australian interest rates: Expectations are that the RBA will lower interest rates again, and that the immediate future looks like a lower rate environment. This is a further blow to self funded retirees looking to live off their super pensions and those for whom a large part of their super is currently held in bank deposits. Lower returns on investments are the “new normal” and the only thing that will change these returns at this time is increased risk in investments – and that brings greater risk to the downside as well.  Speculative investment within super is not good if you want to rest easy at night.  It may prove good for the hip pocket but then again it may not go well at all.  That’s the risk. Lower rates are reflected in the Australian Bond yield curve, to which we have made reference before.  It continues to be in a negative yield curve – a negative portent for our economy generally.

We haven’t talked in this post about other economic indicators such as unemployment, GDP and PMI.  Neither have we mentioned industrial unrest, wages pressure, political issues such as funding for government spending programmes such as the NDIS, Gonski and the Dental Scheme which are looking like blowing a big hole in the Commonwealth Budget.  These issues are all bubbling away in Australia and whilst we have no doubt on the scale of relativities that we are indeed a fortunate country, there remain risks to our domestic economy which provide significant challenges ahead for us all.

The major message coming from the Fed today is that the US Central Bank is going to continue its active and open ended interventions for as long as it takes to improve the employment market in the USA.  There are big consequences for global trade in all this.