Hybrids no contest for bonds, when it comes to true fixed income
“Let’s get one thing straight – hybrids are not fixed income.” This pretty definitive call was followed by “Hybrids don’t have firm maturity dates, so how can they be fixed income?” These statements were made by panel members at a ‘Bond Forum’ for stockbrokers & advisers we hosted in April.
I am passionate about fixed income, because I think it’s something to be passionate about. We’re in business because we think we’re part of a solution to a big problem – you can’t access most corporate bonds and they’re not traded on ASX. Corporate bonds are important because they’re defensive assets that balance growth assets, and you get a better return than term deposits (TDs) 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 didn’t 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.
I’m 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. 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.
Confusion among financial planners
I wasn’t overly shocked. Until the recent ASX debuts of government bonds, bond ETFs and XTBs – hybrids were, for a very long time, the only thing on ASX remotely close to fixed income. Hybrids became the proxy for ‘real’ bonds. The equities-centric retail market, and even ASX called them ‘listed fixed income’, even though they aren’t.
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 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 ‘Listed Fixed Income’ and similar terms, for hybrid issuers. But that hasn’t stopped advisers calling them that.
Investors who thought they’d 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?
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 2000
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 – and must be paid, can’t be deferred, or it’s 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 an ASX-traded 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 underperformed in total returns for significantly higher risk (volatility).
The tide is changing on where hybrids fit, as more brokers and advisers start to reposition them as a separate asset class.
Senior corporate bonds v equities & hybrids: from 2014
Malcolm in the middle
The truth is, hybrids sit between fixed income and equity. Some have more fixed income features – they’re 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 – 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
“I get compensated for the extra risk though; I get more income than the senior bond holders?” Yes, that’s true. Hybrid investors are clearly taking more risk than bond holders, and get better income. But you’ve got to take price volatility into account. There’s 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 “return of capital”, which is very different to equity investment’s “return on capital”, 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 you’re happy to lock money up for that time, then that’s okay, if the hybrid gets called. But is everyone happy locking up their money? Some will be. But look at the majority of TD money for example. It’s in short-term TDs, not 3-5 year TDs, so investors with hundreds of billions of dollars aren’t all willing to lock funds away long-term – 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 shouldn’t be sold as an alternative to TDs generally. If they are – investors need to be made aware of the following:
- You’re assuming the risk the ‘call’ will be deferred (which may be acceptable, as you see it), or worse, the hybrid is converted at a hugely depressed share price.
- You have to buy & hold the hybrid until the call date.
- If you think there’s a chance you’ll need the funds early – you must understand you could have significant capital losses compared to a TD or corporate or government bond.
There is a ‘Client Suitability’ 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 ‘green’ technology – 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 weren’t impacted.
So hybrids are a fair weather friend. When equities are strong, the fixed income features are more apparent. When they’re 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 you’ve got all the downside of equities with none of the upside. No wonder corporate CFOs see hybrids as a cheap form of equity – for them. Meaning it’s 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 they’re 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. If you’re looking to fixed income to provide protection against the volatility of equities, then you shouldn’t view hybrids as part of that because they’re obviously not defensive against equities in the same way as TDs and bonds.
If you’re looking to fixed income as an alternative to short-dated TDs, then you shouldn’t view 3 to 5 year hybrids as part of that alternative plan – unless you’re happy locking up funds long-term and assuming call deferral and conversion risk.
This isn’t to say hybrids are a bad investment product if you fully understand them. But don’t view them as fixed income or defensive. I’ll 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 that’s 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 you’ve 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?
Richard Murphy is the CEO and Co-Founder of Australian Corporate Bond Company