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Tips for success in hybrid investing

Tips for success in hybrid investing

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Hybrids are a unique asset class, but you do not need to reinvent your investment strategy to successfully incorporate them into your portfolio.

The following tips are designed to help both seasoned players and novices navigate the dynamic world of hybrids.

  1. Understand the specifics of the market

Before delving into details such as yields, franking credits and performance, take a step back and consider some of the unique aspects of hybrids.

Firstly, distributions are entirely discretionary. While there are some protections for investors to recoup missed payments, if deferrals persist for longer than 12 months there is the real chance that those coupons may never be paid. With this in mind, we recommend taking some time to understand the company issuing the hybrid, its reasons for doing so, its prior track record if available, and the potential risks that might impact its ability to pay distributions in the future.

Secondly, in Australia distributions are calculated based on a periodically reset short-term interest rate that is added to a fixed margin. This structure is designed to reduce volatility in the capital price of the instrument, but when interest rates are effectively zero, this benefit is severely curtailed. Have an awareness of the future path of interest rates to understand what an expected income profile could look like for your expected holding period, but remember that these can change quickly.

Thirdly, be prepared for volatility in the capital price. While it is true that in “normal” markets hybrids display little, if any, correlation to the share price of the issuer or the broader market, when severe downturns occur, correlations rise quickly. Daintree research shows that over a holding period of seven years, on average there will be at least one period of hybrid price volatility exceeding five percent. That may not sound like much, but in the current interest rate environment that is equivalent to nearly two years of coupon income on average. A nuisance for a buy-and-hold strategy for sure, but can impact perceptions of risk in the asset class, as the next tip considers.

  1. Check your mindset

We were intrigued to come across a 2015 study of hybrid investors by ASIC in partnership with the University of Queensland Behavioural Economics unit. While the study focussed on investor actions and perceptions around hybrids, many of the findings are applicable in a wider context. The key take-aways from our perspective are:

(a) Investors in hybrids exhibit a strong illusion of control bias. This was a little surprising given what we noted earlier regarding the lack of control investors have over certain aspects of hybrids. Nevertheless, the broader implication is that some of the qualities of hybrid securities and their issuers have fostered the belief that investors have more of an influence on investment outcomes than they actually do. This led to an overallocation to hybrids in a portfolio that also offered equities and fixed income.

(b) Many of the same reasons as above saw hybrid investors in the study display overconfidence bias. Australian hybrids have a long history of reliable coupon payments, predictable redemptions and attractive returns. Over time this has fostered a belief that past performance can be relied on as indicative of future performance, which is counter to the best investing wisdom.

(c) The way an idea or story is presented is known as framing bias, and it can strongly influence the decision-making process. When it comes to hybrids, the report states: “The framing effect is likely to be more pronounced for hybrids as many of the risks are not immediately apparent, rendering the risk-return trade-off more appealing than shares and bonds”.

Interestingly, one factor that was not found to be prominent among participants was the influence of branding. Despite the four major banks being almost universally represented in some format in share portfolios, the study found that the brand and reputation of the issuer was not a factor when allocating funds to hybrids.

  1. Have a strategy

In Daintree’s experience, most hybrid investors tend toward a “buy-and-hold” mentality. For many of the reasons already discussed, this has proven to be a successful approach, but should not totally replace a more considered strategic view.

As a professional investor, Daintree has a comprehensive process that includes:

–  clearly defining our addressable universe of investment options, which include hybrids listed on other stock exchanges and the much larger again over-the-counter (OTC) market.

– a proprietary valuation model that draws on the latest advancements in options theory and machine learning.

– a detailed relative value screen to put our valuation discipline into action, and

– a multi-lens risk identification system, supported by a range of tools to manage these risks.

Of course, not every investor will have the time, skillset or inclination to implement such a comprehensive strategy.

At the very least, a strategy could be formulated by simply taking some time to contemplate Kenny Rogers’ advice:

You’ve got to know when to hold ‘em
Know when to fold ‘em
Know when to walk away
And know when to run

So, to sum up..

Hybrid securities offer unique advantages when compared to other asset classes, but from an investment perspective they require a more nuanced approach to best understand and manage risks. Australian investors have enthusiastically embraced hybrids, and we expect this trend to continue while short-term interest rates remain so low. By arming yourself with knowledge and a strategy, you will increase your chances of a favourable hybrids experience.


Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.