by Jim Parker Vice President Dimensional Funds Advisors

Investors are being flooded by a wave of securities known as “hybrids.” These instruments combine the qualities of debt and equity, and offer an additional return over plain cash. So far, so good; but what are the risks?

Hybrids have been around a long time, but there are particular influences on both the supply and demand fronts that are driving a renewed interest in these securities.

From a demand perspective, the volatility in equity markets and a lack of substantial capital gains in recent years have heightened the appetite among many investors, particularly the elderly, for what they see as steady, reliable income.

From the supply side, regulators have responded to the global financial crisis by imposing tougher requirements on the bonds that banks can count toward their regulatory capital. That is leading to an explosion of new types of hybrids in which investors carry greater risk than in the past.

In Australia alone in the space of a few days recently, hybrids totaling around $2 billion were announced by major financial firms, including Westpac, Colonial First State, and ANZ Banking Group. Also pushing out hybrids in recent months have been household names outside the banks like retailer Woolworths and gaming group Tabcorp.

In Asia, the Financial Times¹ reports a surge in issuance of so-called contingent convertible bonds or “CoCos” by European banks. These are complex instruments that convert into shares when capital drops below a pre-defined level.

Now, hybrid securities are a perfectly legitimate way for companies to borrow money from investors. They combine features of debt and shares and often are able to be traded on a secondary market. They are also a legitimate source of returns for investors—provided they are aware of the risks they are taking.

The problem is that the complexity of hybrids is growing at a time when investors are seeking and valuing greater transparency, a point made by Australia’s corporate regulator in a recent warning to investors.²

The Australian Securities and Investments Commission (ASIC) advised those retail investors contemplating hybrids and unsecured notes to compare offers, read and understand prospectuses, and pay particular attention to the risks.

“Retail investors may be attracted by the interest rates offered by household name companies and trusted brands, but hybrid securities should not be confused with government bonds or ‘vanilla’ corporate debt,” ASIC chairman Greg Medcraft said. “In some cases, investors are taking on equity-like risks but only receiving bond-like returns.”

In particular, Medcraft said, investors need to pay attention to terms and conditions that allow the issuer to exit the deal or suspend interest payments. As well, the regulator warned that in some cases hybrids are offering long-term maturity dates of several decades that may expire after the individual investor has died.

While vanilla corporate bonds have set maturity dates, hybrids can have “call” dates—meaning repayment is at the issuer’s discretion. Many hybrid investors are still feeling the pain of that discovery after the events of 2008–09, when banks declined to redeem issues because they needed the capital to bolster their balance sheets.

So, ultimately, investors can find themselves with equity-like risk and bond-like returns. For those aware of those risks and clear about the conditions involved, that may still be OK. But for those who place a high priority on steady, predictable returns and/or capital security, hybrids can be a poor choice.

“The retail market buys the yield and doesn’t always have the ability to fully understand the risk,” one analyst told Bloomberg recently.³

Interest rate offers of 7 or 8%—as we are seeing in Australia now—may look attractive. As always, though, investors would do better to keep their focus on cash flow rather than income. Making the latter requirement the key in choosing one asset over another means they can end up taking on more risk than they bargained for.

It’s an old story, but a familiar one.

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