We all know the importance of location when it comes to buying property, whether to live in, holiday in, or as an investment. Did you know however, that location can be equally important to investments? In this instance, location is not a geographic point or a physical place; instead it’s the location of an investment in the capital structure hierarchy.
What is capital structure?
The capital structure describes how a company finances its operations and ongoing growth plans by using funds sourced in numerous ways. Generally funding sources can be broadly split into debt and equity funding, although hybrid securities may have characteristics of both equities and debt.
Debt is raised from the capital markets and is generally in the form of a bond issue or long-term note payable; the latter must be issued with a maturity date over one year to be considered long-term. Short-term borrowing is also classified as debt.
Debt can be senior secured, senior unsecured or subordinated. Raising debt can be advantageous to companies; interest payments are tax-deductible and in times of low interest rates, debt can be a lower cost source of funding. Importantly, debt funding allows a company to retain ownership.
Equity is raised from the sharemarket and includes shares and preferred shares. It is generally a more expensive option than debt, particularly in a low interest rate environment. On the upside, equity does not need to be paid back if earnings decline; however, an equity holder has an ownership stake and equity represents a right to participate in future dividends declared by the company.
Hybrid securities include some subordinated notes, capital notes and convertible preference shares. Hybrid security holders rank behind other creditors, but ahead of equity, although many hybrids may convert into equity at the time that you least want them to, when the issuer is under financial stress. They are often issued by well-known companies; there were many hybrids issued by Australia’s banks and other financial institutions after the Global Financial Crisis, as they sought to meet stricter capital adequacy requirements and to provide a buffer to protect deposit holders.
What is the capital structure hierarchy?
When you invest in a company, whether buying shares, hybrids or bonds, it’s important to understand the location of your investment in its capital structure. This determines both the risk of the investment and the order in which investors are repaid in the event that the company is liquidated.
Figure one illustrates the hypothetical corporate structure of a bank. As shown, corporate bonds are lower risk than hybrids and equities and, in the event of a default, bondholders would be repaid before shareholders.
Figure one: Capital structure of a bank
Source: Australian Corporate Bond Company
Where corporate bonds fit in the capital structure
The capital ranking of securities also indicates the price stability of each. Corporate bond prices and yields are generally far less volatile than securities ranked below them in the structure, such as hybrids and equities.
As you can see, there are a number of factors to take into account when making an investment decision. It’s not just about the cost of the investment or its expected return, although these are important considerations. It is also about risk; the risk of not receiving the return you expected or, the worse case scenario, losing your capital altogether.