Hybrids no contest for bonds, when it comes to true fixed income
âLetâs get one thing straight – hybrids are not fixed income.â
This pretty definitive call was followed by âHybrids donât have firm maturity dates, so how can they be fixed income?â
These statements were made by panel members at a âBond Forumâ for stockbrokers & advisers we hosted last month.
I am passionate about fixed income, because I think itâs something to be passionate about.  We developed XTBs as a solution to a big problem â you canât access most corporate bonds on ASX. Corporate bonds are important because theyâre defensive assets that balance growth assets, and you get a better return than Term Deposits (TDs)š without the volatility of equities and hybrids.
Australia has had an historic reliance on equities. Diversification meant ‘more-safe-equities’ versus ‘less-safe-equities’, so fixed income didnât feature enough.
Predictability of individual bonds
Yes, bond funds exist, but with diversification you lose a critical feature of individual bonds, being – on the day you invest you know exactly what your return will be (assuming no default). Think about that for a second. No other security on ASX has that feature. Government and corporate bonds are the only things that if you hold to maturity, your exact return is known on the day you invest. We built XTBs so investors could access this and other features of corporate bonds on ASX.
Iâm also passionate about investors not being drawn into believing that hybrids are the same or similar to bonds, or can play the same defensive role.
Hybrids: Causing confusion among financial planners
In February we conducted a survey at the SMSF Association Conference in Adelaide. There was marked confusion with 47% of advisers classifying them as fixed income.
I wasnât overly shocked. Until the recent ASX debuts of government bonds, bond ETFs and XTBs â hybrids were, for a very long time, the only thing on ASX remotely close to fixed income. Hybrids became the proxy for ârealâ bonds. The equities-centric retail market, and even ASX called them âlisted fixed incomeâ, even though they arenât.
Helping us all maintain this erroneous belief pre-GFC was the fact that hybrids can be more bond-like when equities are strong, as they were pre-GFC (see chart). We had bull market after bull market, only punctuated by relatively short-lived crises, like the tech-wreck and the Asian crisis.
In this environment, it was very easy for important features of hybrids to be very effectively masked, as equities charged ahead.
Then the GFC hit us, and the world changed.
ASIC & ASX ban on “Listed Fixed Income”
ASIC started a public education campaign when the damaging features of hybrids, buried deeply in their complex terms started to rear their heads, during and after the GFC. This led ASIC and ASX to ban the use of âListed Fixed Incomeâ and similar terms, for hybrid issuers. But it hasnât stopped advisers calling them that.
Investors who thought theyâd bought fixed income saw their investments following equities down the drain. Was this what fixed income does when equities crash? Was fixed income positively correlated with equities?Â
Of course not, and the chart shows the capital stability and even negative correlation of corporate bonds in 2008/09. This is how real fixed income behaves. This is what defensive assets do.
Senior corporate bonds v equities & hybrids: from 2000Â
Cumulative Returns 2000 to 2015
ANNUALISED VOLATILITY | ANNUALISED RETURNS | |
AUSTRALIAN CORPORATE / CREDIT | 2.32% | 6.96% |
S&P / ASX ACCUMULATION 200 INDEX | 15.28% | 8.58% |
ELSTREE HYBRID INDEX | 5.68% | 6.29% |
Source: Bloomberg, Elstree Investments & Australian Corporate Bond Company
So why do I think that hybrids are not fixed income?
For me, fixed income has three common features:
- A hard maturity date, like bonds or TDs – you get your capital back or else the issuer/bank is in default. There can be no ability to defer it.
- No ability for the issuer to convert into equity – period.
- Income is known, whether fixed or floating â and must be paid, canât be deferred, or itâs a default.
Hybrids fail each of these tests, while all bonds and TDs do not. All call-dates are optional and can be deferred, all hybrids can convert to equity, and all dividends are optional and often non-cumulative.
The short-term chart below has XTBs as a proxy for corporate bonds. It has similar patterns, given the torrid time equities had in 2014, 2015 and into 2016. Equities and hybrids were far more volatile than bonds/XTBs. Over both the short and long term, hybrids under-performed in total returns for significantly higher risk (volatility).
The tide is changing on where hybrids fit, as more brokers and advisers start to re-position them as a separate asset class.
Senior corporate bonds v equities & hybrids: from 2014Â
 
Malcolm in the middle
The truth is, hybrids sit between fixed income and equity. Some have more fixed income features â theyâre more debt-like, and some are more equity-like. Their volatility is driven by their equity-like features.
Hybrids are designed to protect banks, not your portfolio. Some of the more debt-like hybrids that were more defensive for you, have now been banned by APRA because they were not defensive enough for banks. APRA wants hybrids that are easily convertible for banks, which automatically means they need to be more risky for you. The new style of hybrids are more suited to playing their actual role in a crisis â which is to fall in front of the train to protect the rest of us.
APRA regulates how and when hybrids are called by banks. It decides if they will be deferred or converted. APRA is there to protect the banking system, not individual investors. It does not determine if a bank buffer like a hybrid is suitable for individual investors. The UK regulators have banned hybrids for retail investors.
Fair weather friend
âI get compensated for the extra risk though; I get more income than the senior bond holders?â
Yes, thatâs true. Hybrid investors are clearly taking more risk than bond holders, and get better income. But youâve got to take price volatility into account. Thereâs no point in 6% income if you have 8% capital loss.
Investors are told to ride out the volatility and wait for the call date. But fixed income investment is philosophically about âreturn of capitalâ, which is very different to equity investmentâs âreturn on capitalâ, so the uncertainty of the call date and whether APRA might defer it is one point.
But that call date may be 3-5 years away. If youâre happy to lock money up for that time, then thatâs okay, if it gets called. But is everyone happy locking up their money? Some will be. But look at the majority of TD money for example. Itâs in short-term TDs, not 3-5 year TDs, so investors with hundreds of billions of dollars arenât all willing to lock funds away long-term â people need to know they can access their funds. If hybrids continue to be volatile and you need to sell, you could incur a significant loss. That is not what defensive investment is about.
In my opinion, hybrids shouldnât be sold as an alternative to TDs generally. If they are â investors need to be made aware of the following.
- Youâre assuming the risk the call will be deferred (which may be acceptable, as you see it), or worse, the hybrid is converted.
- You have to buy & hold the hybrid until the call date.
- If you think thereâs a chance youâll need the funds early â you must understand you could have significant capital losses compared to a TD or corporate or government bond.
There is a âClient Suitabilityâ question to my mind for advisers making the decision to recommend a client switches from TDs into hybrids, if the allocation is part of the fixed income part of the portfolio.
Hybrid prices are much more volatile than bonds. When Volkswagen made its shocking announcement last year about its âgreenâ technology â its equities fell 50%. Its hybrids fell 25%. Its senior bonds fell 4% and recovered when the market worked out it was still going to sell cars and bond holders werenât impacted.
So hybrids are a fair weather friend. When equities are strong, the fixed income features are more apparent. When theyâre in strife, hybrids suddenly become more equity-like. Market stress and uncertainty cause their worst features to roar into life after lying dormant when the sun was shining.  Basically youâve got all the downside of equities with none of the upside. No wonder corporate CFOs see hybrids as a cheap form of equity â for them. Meaning itâs expensive equity for you.
The long-term performance chart shows that, fixed-rate bonds have beaten hybrids in total returns for significantly less volatility. Corporate bonds have been a safer haven for investors because theyâre negatively correlated to equities.
Defensive assets and TD alternatives
Defensive assets should protect investors from the adverse moves in the offensive part of their portfolio, which is more often than not, equities. Â If youâre looking to fixed income to provide protection against the volatility of equities, then you shouldnât view hybrids as part of that because theyâre obviously not defensive against equities in the same way as TDs and bonds.
If youâre looking to fixed income as an alternative to short-dated TDs, then you shouldnât view 3 to 5 year hybrids as part of that alternative plan – unless youâre happy locking up funds long-term and assuming call deferral and conversion risk.
This isnât to say hybrids are a bad investment product if you fully understand them. But donât view them as fixed income or defensive. Iâll leave you with this test: Count up the number of times a bank/broker has called you with that hot IPO or heavily discounted equity issue thatâs going to be hoovered up – the ones you read about being allocated to top fund managers and the super wealthy. Then think of the hybrids youâve been offered since the GFC. Do the top fund managers elbow you out of the way to get their hybrid allocation? Do any fund managers invest in the ASX listed hybrids? Why are all the hybrids sold to mums & dads?
To learn more about Corporate Bonds, XTBs and the world of opportunity they offer investors, our new infographic Your Guide to Corporate Bonds – A World of Opportunity is a good place to start.
š Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.