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In the hunt for yield, investors are taking huge risks. Hybrids this discussion.
November 13, 2017
Summary: In the hunt for yield, investors are taking huge risks. Hybrids and Junk bonds (high yields bonds) typify this excessive risk-taking, which is currently found in many other sectors. BEWARE: In next financial crisis, very large capital losses can be expected in this space.
Discussion: Hybrids are much riskier than bonds. They started out in the late 1990s as having characteristics much more like term deposits…. And we used them for our clients then. Good interest rate, high degree of certainty of getting your funds back with certainty at “maturity” … and so there was a high degree of capital certainty.
But now, for at least of these most of these instruments, the capital certainty is largely gone …. Now they have characteristics much more like shares. The line which sums them up best I believe is that “in good times, they give you a return much more like fixed interest and in bad times, returns are much more like shares.” One discussion of this is here: https://cuffelinks.com.au/hybrids-good-bad-ugly/
The following commentary from Unisuper, is also well worth reading.
Notwithstanding that the above coupons do look attractive, and the issuing companies are highly reputable, UniSuper has not participated in any of the recent hybrid issues. While there are specific reasons unique to individual securities deterring us from participating, the following highlights some key considerations we have taken into account in our decision making.
Illiquidity As a large investor, UniSuper is able to strike the best deals from service providers, participate in attractive capital raisings, directly invest in large-scale unlisted investments such as property and infrastructure, and so on. However, in the case of hybrids, scale actually works against us as most issues are largely placed in the retail market and very little is traded. Therefore, it is difficult for UniSuper to obtain a meaningful amount or to trade reasonable volumes in the secondary market. This contrasts with the senior debt market, which is far more liquid.
Structural Flaws There are many different nuances within various hybrid structures, however one problematic feature we have seen in several recent issues is mandatory coupon deferral. This refers to the situation where the operating performance of the company deteriorates to a point where certain tests (e.g. interest cover, ratings downgrade) have been breached, and the issuing company may potentially suspend interest payments on the hybrids – in some cases this may be up to five years. Given that an investor would see hybrids as an income-generating security, the risk of deferred coupons needs to be considered carefully.
In some cases, it is not the coupon deferral per se that we view as unattractive, it is the ability of the company to continue to pay dividends on ordinary shares or even buy-back shares whilst the coupon deferral is in place. In such a scenario, which may be highly unlikely in practice, we view the hybrid as being technically subordinated to ordinary equity, which is not a position we want to be in.
Equity volatility without equity returns As mentioned above, many investors see hybrids as a good way to earn equity-like returns for bond-like risk. However, the experience of the financial crisis gives cause to question this view. The graph below shows the total return of an index of bank-issued hybrid securities against comparable bank equity and bond (senior debt) indices.
For interest, here are a few more interesting articles about the chase for yield:
Higher current yield reflects greater risk. This is true across asset types and among securities within the same type. Investors who chase yield are gambling, knowingly or naively, that the market is wrong and that their principal will not be significantly impaired. In the current artificial low-yield climate, risk to capital is real but is being ignored more than usual, as investors seek to replicate the income streams available pre-2007.
This article covers several income-oriented asset types: high-yield bonds, preferred stocks, so-called hybrid preferreds, real estate investment trusts (REITs), master limited partnerships (MLPs), closed-end funds and utility common stocks. While the capital soundness differs by asset type, one key caution is equally true for all: High yield means high risk.
This last few years is the only time in history that I am aware of where there has been a yield bubbles, where investors desperately scrambled for yield .. and often took huge risks to try to get that yield. However, I guess this yield bubble is not surprising given that yields have been over recent years at a lower point that any other period since 1900 - and that includes the Great Depression. In that context, it is interesting to contemplate the following pearls of wisdom from some very experienced investors.
“I have come to believe that the forming and bursting of great investment bubbles are by far the most important things that happen in investing.”Jeremy Grantham 31/3/14 newsletter.
“I have owned every sector of the market, because at some point, they are all out of favour.” Sharon Fay – Alliance Bernstein AFR 26/2/2014
The corollary to Sharon's comment is - that all sector experience speculative bubbles from time to time - which is yet another reason to not be too dogmatic any any particular style of investing. Rather it is better to have a tool-kit of investment strategies so youcan adapt your investment approach to the risks and opportunities of the time.
I'm busy working on my blog posts. Watch this space!