Investing

Major companies are raising billions of dollars through hybrid issues, which come with a whole new language to learn in order to understand them. Although notes (Woolworths offer) or convertible preference shares (ANZ CPS3 issue) bear some characteristics of equity and convert to shares after a few years, they still mostly count as bonds, which are different animals.

Nothing beats reading the prospectus to find out about a hybrid issue you’re interested in, although most retail investors rarely do more than glance at the investment overview. But there are many terms puzzling to those who are used to shares. Below we provide an explanation to some of them:

Unsecured

Corporate bond issues feature a range of terms referring to the security offered, should the company hit the wall. The best is senior secured debt, followed by senior debt, then subordinated debt, and hybrids on the bottom. This means investors in hybrids rank just above shareholders in a corporate collapse, so they may get some of their investment back. Shareholders typically don’t get anything in a company collapse.

Subordinated

As above, this means the debt is well down the ranking when it comes to sharing out what may be left of the company’s assets after a collapse.

Ranking

For those still confused by the above terms, there should be a section in the prospectus spelling out where the securities rank in the event of a wind-up. The Woolworths notes II issue, for example, ranks behind all senior debt but above shares and junior debt.

Preference shares

One of the earliest form of hybrids, these instruments rank above ordinary shares in a company collapse and, traditionally, pay a fixed rate of interest.

Convertible preference shares

As the name suggests, they convert to shares at a set time. Depending on the issue – and they are all different – they can be converted at the behest of the shareholder, the company or at a certain time, or they can be redeemable as well as convertible.

Redeemable

The company will give you your money back. Just when that happens depends on the issue, but can be at request, triggered by certain events or just by reaching a date. This is often the date on which the interest rate payment is made. Issues can be either redeemable or convertible or even both, again depending on just how it is set up.

Perpetual

Where the issue has not been set up to be called (converted) or redeemed after a certain period, it just keeps going. But there must be some way to pay out the security.

Reset

Technically, reset preference shares are perpetual but the terms of the reset preference share issue, notably the rate of return, are changed at set periods, usually every five years.

Step-up

Step-up preference shares are the most common type of corporate hybrid. If they are not redeemed or converted by a certain date, usually five years after being issued, then the rate of return is raised or stepped up to a higher level to compensate the security holder.

Stepped-up

Securities where the interest rate has been increased.

Valuation

Valuing hybrids is very difficult, even for the professionals, as they vary so much. Valuation involves assessing the credit risk (higher than bonds, lower than shares) and the interest rate risk. Then there is the risk of what sort of investment the shares may be in three to five years’ time, if the issue is convertible. Private investors are more likely to go on a gut feeling.

Fixed or floating

The interest rate attached to hybrids can be either fixed or variable, where the variable rate is quoted as a well-known rate plus a margin – say the bank bill rate plus a margin.

Deferable interest payments

The issuer may opt to defer a payment, but still has to make that payment later. The issue is then a cumulative one. Skipping on payouts, cumulative or not, is not a good sign.

Events or conversion conditions

If and when various events occur, those holding hybrid issues are entitled to their money back. These typically include the company issuing the hybrids changing hands, the relevant credit rating being cut to below investment grade, or the accounting standards changing so that the hybrid issue can no longer be classified as debt.