Term deposits have been a safe haven in recent years, but now that interest rates are on the way down, investors are casting their net wider in the search for income. Increasingly, they are looking at hybrid securities.
Like exotic hybrid plants, hybrid securities combine features of two different species of investment products, bonds and shares. They tend to be less volatile than shares and typically offer higher interest rates than bonds. While this is a winning combination for many investors, they are not risk-free.
Attractive interest rates
Hybrid products such as income securities, convertible notes and reset preference shares typically offer appealing income streams and potential for capital gains (or losses). This is because hybrids can be bought and sold on the share market once the company issuing the product has made a public offer.
The way the income is paid varies from product to product. Some hybrids pay a fixed or floating rate of interest a few percentage points above the variable bank bill rate. Others pay income in the form of dividends with franking credits attached.
For example, a Bendigo and Adelaide Bank hybrid issued in September had a pre-tax yield of 8.53 to 9.03 per cent1. At the time the dividend yield on its shares was about 7.7 per cent.
While the interest on hybrids can be appealing compared to term deposits and in some cases shares, investors need to weigh this up against the risks. Hybrids have less potential for long term capital gain than shares, and the capital and interest payments are not guaranteed like they are for a term deposit.
Understand the risks
Depending on the terms of the hybrid issue, companies may have the right to defer interest payments. They can also decide not to redeem the securities for cash but convert them into shares in their company instead. Hybrids are a form of debt issued by banks and other companies to raise capital. As with all forms of debt, you need to understand where you sit in the pecking order of creditors.
If the issuing company collapses, hybrid investors will be paid out before ordinary shareholders but after all other creditors. Interest or dividend payments on its hybrids can be paid before dividends on the company’s shares.
Your financial adviser can help you assess the suitability of these investments based on your risk profile. For investors who understand the risks, hybrids offer an attractive addition to the income component of a diversified portfolio.
1 ‘Issue of new Tier 1 Convertible Preference Shares and redemption of Reset Preference Shares’, 24 September 2012, Bendigo and Adelaide Bank, <http://www.