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.

Investing in a QE World

www.bbc.co.uk

We've written a lot about global macro issues lately.  The debt issues of Europe and the USA are enormous and ongoing.  They remain unresolved.  The statistics are staggering: the combined central banks of the world have "printed" so much money since the GFC that their balance sheets now constitute a third of global equity values: see

Bianco Research: www.arborresearch.com, 27 January 2012

We maintain Australian investors need a global context for their investment decisions.

What is QE?
Quantitative Easing ("QE") is an expanding of balance sheets via increasing bank reserves.  The purpose of QE, as explained by this Bank of England video,  is to increase bank reserves through purchases of fixed income securities in order to lower interest rates.  This makes fixed income securities relatively unattractive/overvalued and pushes investors out the risk curve.  This should increase buying for riskier assets such as stocks, pushing them higher in price.  Theoretically these higher prices should lead to a wealth effect and increased economic activity. see

Everybody (else) is doing it
The  major economies of the world are exercising monetary policy in order to stimulate economic activity as the first chart shows.

By contrast, the Australian economy is undergoing an unprecedented mining boom at the same time as other sectors of the economy are contracting.  We call this our "two-speed" or "patchwork" economy.  Some argue it's a manifestation of "dutch disease".  The Gillard Government's trade policy is premised on the following:

Non-mining businesses seeking to retain their employees and contractors will need to bid for them against extremely profitable mining-related businesses. And since the mining boom is not confined to Australia, overseas bidders have also entered the market for Australian expertise. Similarly, the prices of materials and equipment used in mining-related activities are being bid higher.
An independent, inflation-targeting Reserve Bank, confronted with these price pressures, would be obliged to consider raising interest rates to prevent inflation from rising above its 2-3 per cent band of tolerance. The blunt instrument of interest rates hurts non-mining businesses and regions of Australia, accentuating the patchwork economy.
A further natural economic consequence of the mining boom is a rising exchange rate, the Australian dollar having surpassed parity with the greenback in November 2010 for the first time since well before the currency was floated in 1983. A high Australian dollar has the desirable consequence of putting downward pressure on prices by lowering the cost in Australia of imported goods and services — taking some pressure off the Reserve Bank to lift interest rates. But a high Australian dollar is also damaging our import-competing and export industries, weakening their ability to compete for productive resources against mining-related industries. While this, too, has an anti-inflationary effect, it is more deeply embedding the patchwork economy.

What to do?
Where does all this money printing  leave the Australian investor?  Holding your deposits in cash eats away at their value longer term if inflation kicks in.  How does the SMSF Trustee determine the best course for achieving the returns required to fund retirement?

You could take the risk of riding the upward trajectory of the risk markets such as stocks.  The risk is described well here

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets.  As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.
When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light.  Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling.  The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.
The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know.

A new option for Australian investors
One new option is to consider a high interest cash exchange traded fund such as Beta Shares new offering, the Australian High Interest Cash ETF.

Characteristics of this product include:

• diversification of investment portfolio - the product as part of a cash or term deposit allocation aims to earn a higher rate of interest than the 30-day bank bill swap rate after fees and expenses
• suitability for cash flow for SMSF pension holders - monthly income payments may be made
• the ETF is backed by deposit with an Australian bank trading under new ASX AQUA rules
• investors buy and sell units in the ETF through a broker (and pay brokerage)
• as interest is earned each day on the deposit, the value of the ETF will rise, providing investors with liquidity, coming with the ability to sell at any time without penalty (in contrast to term deposits).

We note:

• the Government Guarantee on bank deposits for Australians is now limited to $250,000 per deposit with one bank/ADI (authorised deposit taking institution).  Participation in a cash ETF does not equate to a deposit for the purposes of the government guarantee.
• A Cash ETF provides the possibility for a spread of risk from one institution to many, exposing the investor to multi-party credit risk akin to the former Macquarie Bank Cash Management Trust product.  (Note: the current Macquarie CMA attracts single party credit risk). 
• the BetaShares Cash ETF currently only offers single bank risk (Westpac) though the PDS describes the possibility of deposits with other major Australian Banks: see here Accordingly, we recommend this is a product to watch, and once they and others offer diversification of credit risk we would recommend our clients to consider these products.

There are similar new products coming onto the market in Australia such as offerings from  iShares and Russell Investments.  You can read more about these products in The Age/SMH or call us to have a chat about your needs and risk appetite.  

Please note this is not financial advice and you should not rely on opinion/s expressed in this blog post.

Super Gamble | Robert Gottliebsen | Business Spectator

Short-changed by a Super Gamble

SMSFs tailor their investments to suit their risk appetite. This is a key advantage over industry and other retail funds as shown today by Gottliebsen in the context of Australian equities' risk to commodity and financial stock prices: see
Short-changed by a super gamble Robert Gottliebsen Commentary Business Spectator

Investment Allocation: SMSFs increase holdings in ASX listed shares

Popularity of listed instruments on the rise - but the real shift is to cash

Investor Daily reports today the latests ASX research into share ownership has shown self-managed super funds (SMSFs) are allocating a larger proportion of their investment portfolios to listed investments.

Also of note:

• the proportion of SMSF investments in unlisted managed funds have dropped to 16% from 46% in 2006 and 38% in 2008
• residential property holdings are down from 19% in 2008 to 12% in 2010; commercial property made up 14% of SMSF portfolios in 2008 down to 8% in 2010
• SMSF holdings in real estate investment trusts and listed property trusts fell from 20% in 2008 to 4% in 2010.

Australian equity holdings have stayed steady at 52% but SMSFs have shied away from overseas shareholdings, down from 9% to 3% allocation in 2010.

Where has all the money gone?  The underlying assumption in this piece is that investors have largely gone to cash - secured returns of around 6% proving to be very appealing to SMSFs' risk appetite.

See article by Darin Tyson-Chan: http://www.investordaily.com/11558.htm 

Introducing: Sage Online

Sage Online - a great wrap account alternative

We are very pleased to announce the introduction of Sage Online for our Self Managed Super Fund (SMSF) clients.

As a trustee of a SMSF it can be very hard to keep track of a diversified investment portfolio.

Sage Online allows you to check daily balances of all your investments, access performance reports and it provides all the required information for preparation of financial statements and tax returns.  Clients will be able to access Sage Online via our website: www.sageadvisers.com.au

A secure login password will be provided to clients on establishment of their account.

Sage Online:

• Provides online data feeds of transaction data from participating banks, fund managers and stock brokers
• Renders obsolete the need to provide bank statements, dividend slips, share purchase & sale details and fund manager transaction data
• Provides automatic daily unit pricing for both managed investments and shares
• Uploads data and wherever possible matches transaction data and posts the transactions to the relevant account
• Provides online reporting allowing you to view super fund information updated daily. SMSF trustees can base investment decisions on current data rather than historical reports for previous periods
• Allows SMSF trustees to become more active and gain a better understanding of investing.

What are the costs?

There is an annual licence fee of $275 per fund for our clients.

How does this compare to other options available to our clients?  Wrap accounts offer similar functionality except they don’t provide the software to prepare the accounts and income tax return.

Most financial planners and advisers use these wrap accounts for their clients however we have always considered them to be way too expensive for the benefits they provide and hence we have never used them.

Wrap accounts are charged on a sliding scale of the funds under management (FUM) basis.  We have compared the Asgard, BT & IOOF wrap fees so you have some idea of their annual costs.

    FUM              ASGARD       BT        IOOF

   $100,000        $820        $943        $950

   $250,000     $1,742     $1,768     $1,775

   $500,000     $2,511     $2,893     $3,150

   $750,000     $3,280     $3,768     $3,150

$1,000,000     $3,536     $4,393     $3,150

$1,500,000     $4,048     $4,893     $3,150

An advantage wrap accounts have always enjoyed is online processing of managed fund acquisitions & sales and the attendant elimination of paperwork.  This advantage will be removed once the ASX completes the introduction of its new system called Aqua which will allow managed funds to be bought and sold initially via Bell Direct and later CommSec and E*Trade. Our clients will have full access to Aqua via their discount broker.

We think high cost wrap account fees will soon be a thing of the past.

We look forward to be able to offer Sage Online in the future to Trusts, Companies and Individuals.  This is in the development pipeline. For now we can offer this service to our SMSF clients and we are very excited about that!

The Future of Financial Advice

Treasury has announced a report indicating the future direction of the financial advisory sector: The Future of Financial Advice, Sen Chris Bowen, 26 April 2010 which aims to abolish commission based remuneration for financial advisers.

Sage Advisers’ clients should feel reassured to know that in all areas of proposed legislative and policy reform in relation to commissions (e.g. trailing commissions) payment structures, professional qualifications and regulations we are already compliant. Indeed, we are “ahead of the pack” in terms of our “fee for service” structure and our independence philosophy. We established our firm in the belief that a financial advisory firm in the 21st Century cannot operate under the commission based structure of remuneration with its inherent conflicts of interest.

We go further by benchmarking our portfolios against industry sector averages.

Sage Advisers welcomes the proposed government changes due for commencement in July 2012 based on what has been mooted to date. It will be interesting to see if the government has the courage to change the life and general insurance industry commission based structures as well?

Hold 'em or fold 'em?

Just as the Kenny Rogers classic “Coward of the County” ponders whether to play or to fold the cards, you may be facing a similar quandary in your investment portfolio.

The VIX Volatility Index has risen 30% in the last fortnight based on the debt crisis in Greece and the uncertainty facing the rest of Southern Europe.

There are considerable negative reports in the international press.

In contrast, the Australian stock market has recovered a significant proportion of its GFC related losses and we are constantly being told how strong our local economy is performing with our banks starting to announce extraordinarily strong results. But where are we headed?

The idea that you simply “hold onto your investments because eventually the market will go up” is not the best investment strategy.

Your risk appetite will differ from the next person. You know what keeps you awake at night and your family knows whether you can relax on the weekend. It is of critical importance that you communicate your “risk appetite” to us as your advisers. It may also change over time.

Selling can be a good risk minimisation strategy during times of uncertainty. It is something you should seriously consider. You can always buy back in... the next day, week or in months to follow.

Market Update

There are so many numbers being reported on the movement of the stock indices. It might be useful to put them into some context for you.

The Australian All Ords index was 6,873 at its market high and 3,091 at its recent low: a 55.0% fall. At 31 March 2009 it was 3,547: a 14.8% rally, still 48.4% below its market high.

The US Dow market high was 14.198 and has a recent low 6,470: a 54.4% fall. It has rallied to 7,609 (17.6%) at end of March but still 46.4% down on its market high.

The MSCI World index has fallen 59% from market high to recent low. It has rallied 16.8% from recent low to 31 March 2009 and would require a 108.9% rise to recover the market high, being currently 52.1% below its high.

The Australian Property Trust index (XPJ) was 2,553 at its market high and 547 at its recent low: a 78.6% fall. At 31 March 2009 it was 664: a 21.4% rally. This index needs to rise a whopping 284.5% from here to recover its market high; it’s currently 74% down.

China’s stock market has fallen 70.4% from its market high to recent low. It has rallied 30.7% but is currently 61.3% below its high.

Quoting movements in percentage terms can be a little confusing as a 33% fall will require a 50% rise to regain the initial loss.

The big question for all investors is have we seen the bottom or is this just a bear market rally and the bottom is still ahead for us?

For our clients we remain cautious. We took our clients to significant cash positions in July 2008 and progressively since. This has protected their wealth and positioned them well to ride this crisis.

The investment decision of whether to buy or sell is becoming more difficult. On one hand it is likely the economic news will worsen in the short term but on the other low interest rates and the significant government stimulus programmes should take effect. 

During a period of extreme market volatility such as now, we counsel investors to remain flexible and patient.