On the surface, hybrids can seem like a no-brainer. They pay a regular income, offer downside protection, are less volatile than equities, and can provide capital growth and franking credits. But dig a little deeper and you soon discover that they’re complex investments that can carry risk.

To help you make heads or tails of hybrids, Roy Keenan, Co-Head of Australian Fixed Income at Yarra Capital Management, shares his six principles for investing in hybrids.

1. Determine if the issuer is investable from an ESG perspective

Environmental, social and governance (ESG) considerations have grown in importance in recent years and for good reason—they can impact the value of an investment.

“As well as being necessary for understanding and quantifying risks, they are a critical indicator of the sustainability and financial performance of an issuer and should form a central part of your due diligence process,” explains Roy.

Roy and his team assess each new issuance based on the following ESG criteria:

i.   Sustainability: is the issuer’s ESG above a threshold level and as such investable?
ii.  Relative value: ensuring risk-adjusted returns reflect an issuer’s ESG performance.
iii. Consultation: sending price signals to the marketplace to encourage issuers to adopt better ESG.

2. Examine the issuer and assign a credit rating

You need to be certain that the underlying business can support the commitments of the security it is issuing, otherwise you risk throwing good money after bad. Just like a ratings agency, the team does its own credit assessment to determine an issuer’s credit worthiness (i.e. how likely they are to repay their debt).

To arrive at a credit rating, we assess four key profile ratings:

• Financial: earnings and cash flow estimates, balance sheet analysis and key credit ratios.
• Business: industry structure, competitive position, liquidity and management.
• ESG: environmental, social and governance factors.
• Market: relative size, market-to-book value, probability of default and other solvency measures.

“Our investment process considers the future, incorporating key structural themes and forecasting earnings and debt serviceability three years forward. We subsequently ensure returns adequately reflect the risk, focusing on constructing higher risk adjusted return portfolios,” says Roy.

3. Assess the documentation and be clear on all terms and conditions

They say the devil is in the detail and that’s certainly the case when it comes to hybrid securities. With no two the same, you can’t rely on what you read in one PDS or prospectus to cover you for what’s in another. If you’re not clear on the risks covered in the terms and conditions, you could unintentionally take on additional risk, forgo higher returns and/or lose your capital.

Risks that are buried in fine print that can be misunderstood or overlooked by investors include:

• an option for the issuer to exit the deal or suspend interest payments.
• long term maturity dates that can stretch out to several decades.
• an issuer subordinating the instrument, i.e., giving it a lower rank.
• an investor being issued with shares rather than have their capital repaid.

“Security documentation is an area which can be easily overlooked by investors. We analyse documentation on all securities in the marketplace, ensuring we’re not subscribing to any documentation risks we are not comfortable with, or which are not factored into pricing,” says Roy.

4. Calculate the value of inherent risks

The issuer/security risks are multi-faceted and include credit, market, liquidity, equity and interest rate risks.

“All our analysis is focused on risk adjusted returns, i.e. ensuring we are appropriately compensated for the risks taken. We evaluate these risk in the form of a credit rating calculation and subsequently choose to only invest in the securities that offer the highest return for the underlying calculated risk,” says Roy.

5. Ensure you’re being compensated for the risk

Hybrids are a blend of equity and debt. Some behave more like equities, making them more volatile. For these types of securities, we demand a higher return to compensate for the increased risk.

“You also want a high degree of certainty that not only will you get regular distributions, but you’ll also get your capital back. That’s where doing detailed research on the issuer pays off,” says Roy.

Investment grade issuers—those with a BBB to AAA rating—have a very low risk of default compared to non-investment grade securities. While they typically offer a lower yield, you can be more certain of receiving regular distributions and getting your capital back. Generally speaking, the lower the credit rating, the higher the risk (and potentially the returns).

6. Size the opportunity according to key criteria

Having a proven investment process in place ensures you leave no stone unturned when it comes to assessing the risks and merits of a hybrid. Roy and his team apply the following criteria when assessing opportunities.

• Start by looking at the quality of the issuer. Read the PDS for each hybrid in detail and do your research on the security.
• Understand how the hybrid will behave under different market conditions.
• Diversify your investment accordingly, i.e. spread your risk across a range of issuers/securities—generally more than 50 are required for a truly diversified portfolio.
• Tier your exposures according to the risk being taken, with higher risk securities making up the lowest percentage of AUM.
• A diversified portfolio increases the defensibility of income; reducing volatility as well as any potential drawdowns

Invest in more

The Yarra Enhanced Income Fund offers investors access to a professionally managed portfolio of diverse securities, which are generally not accessible by retail investors. It invests primarily in Australian investment grade securities, to provide regular distributions, modest capital growth and some franking credits, with less volatile returns.