‘Through the looking glass’ is an expression that is today used to mean something on the strange side, in the twilight zone, or in a parallel world. It comes from Lewis Carroll’s novel Through the Looking-Glass and the strange and mysterious world Alice finds when she steps through a mirror. The term can also be used when examining the role of hybrids in the investment world, given the number of issues facing them at the moment.
In some sense the hybrid market has always been a somewhat strange world, being a mixture of debt and equity which are typically considered discrete asset classes. Hybrid structures are governed by APRA, overseen by ASIC, may have franking credits and hence involve the ATO, are reviewed by ratings agencies, sometimes listed on the ASX and linked to the credit quality of the issuer. Strange indeed. But despair not, if you would like to invest then as a starting point you can wade through an IPO document that are often over 100 pages long.
The point is that they are a complex and changing beast that require close attention. This is highlighted by several current key issues that have the potential to influence the direction and design of the market and hence investors need to pay attention.
The Australian hybrid market has long been a favourite of retail investors who have sought income. With retail investors lacking the ability to access the full range of assets across the fixed income market (more on that in another piece) hybrids appear to be a solution for many investors.
The history of the market has been long and varied and tends to be a moving feast given ongoing changes to what is a complex product. We are seeing several current developments investors should be aware of:
APRA has released a discussion paper on increasing the loss-absorbing capital predominantly for the big four Australian banks, which could increase the supply of hybrids. Post the GFC the regulators have focused on reducing systemic risk in the banking sector. Whilst it’s only a discussion paper at this stage, it is a familiar theme. Changes have the potential to have a notable influence on amount of supply and pricing in the market. Watch this space.
ASIC is involved in potentially making it more difficult for retail investors to access hybrids as a result of the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Bill 2018 that’s been introduced to Parliament. Again, the final outcome is unclear at this stage but the regulator is clearly concerned that investors may not fully understand the risks involved with hybrids and are hence looking to address this. It’s worth noting that some offshore jurisdictions already prohibit retail investors from holding hybrids directly.
The potential franking credit changes proposed by Labor has the potential for some investors to question the use of franked listed hybrid securities. This may influence behaviours of certain investors if their post-tax expected returns are lower.
Uncertainty could be further amplified in the bank sector with the royal commission findings and ongoing questions on the profitability of the major banks in the event of a housing market adjustment.
We believe the combination of these issues could present continued headwinds for the market. Potentially greater supply, lower demand, and pressure on bank profitability can impact the pricing of the hybrid market. We are not suggesting that hybrids are necessarily inappropriate; in fact they remain one of the asset classes we consider in our broad investment opportunity set. Rather investors should ensure they remain abreast of the risks and market developments and be sure they are being adequately rewarded for lending their money. We are currently cautious and continue to monitor developments.
In some sense the hybrid market has always been a somewhat strange world being a mixture of debt and equity, and it is clearly complex and changing in nature. Current developments may impact the pricing of the market that we currently see as on the expensive side of fair value. We currently consider hybrids to remain a viable investment option, but are conscious as the landscape continues to change. Investors need to pay attention to the total exposures they have in portfolios and how to manage the overall risk. These will be key in dealing with potential volatility and vulnerabilities in the market as change occurs.
Published by Mihkel Kase, Fund Manager, Fixed Income, Schroders