Are Aussie hybrids still a safe choice?

Hybrid securities are a popular choice among investors seeking franked income returns, generally higher than those available from regular bonds or cash, and relatively low capital volatility. But with the great bond bull market ending, analysts warn the days of outsized returns may be over.

Rising bond yields and falling prices saw the AusBond Composite Index post its worst return on record in the March quarter 2022, returning a negative 5.88%. March was also the worst month on record with a negative 3.75% return.

In comparison, the ASX 200 Accumulation index rose by 6.89% in the March quarter, helped by stronger resource stocks.

“Trends spanning decades of falling yields and lowering interest rates are now coming to an abrupt halt,” fixed income specialist BondAdviser said in its March 2022 review.

“The fixed income market is no longer the set-and-forget operation it has been since the 1990s.”

MORE ON THIS TOPIC: What's driving the historic bear market for bonds?

BondAdviser also continues to warn against “duration exposure” in an environment of rising inflation and interest rate expectations. Duration describes interest rate risk. The higher an investment’s duration, the more its value falls if interest rates increase.

YTD domestic performance

Source: BondAdviser, Bloomber, as at 31 March 2022

Hybrids are financial instruments that have both equity and debt features. Common varities include subordinated notes, capital notes and convertible preference shares.

Rising rates

Central banks around the world including in US, New Zealand, Canada and the United Kingdom have begun hiking interest rates putting further downward pressure on bond prices.

The Reserve Bank of Australia raised the cash rate to 0.35% for the first time since 2010 earlier this month and signalled more hikes to come as it launched its campaign to quash inflation and wean a buoyant economy off years of pandemic-era stimulus.

The Board now expects inflation will hit 6% this year, almost double the 3.25% it forecast in February, before declining back to the bank’s preferred target range of 3% by 2024.

Economists NAB and AMP Capital see the cash rate hitting 1.5% by December. Trading in derivatives markets implies a cash rate of over 2.9%.

Hybrid impacts

BondAdviser director John Likos says the current environment requires the comfort of a strong issuer and an interest rate risk hedge. That points to the “higher quality hybrid issuers” such as the major banks.

“One of the benefits of hybrids is their floating rate note nature which benefits from higher benchmark rates as this is reflected in a higher future distribution,” he says.

“The strength of major issuers domestically and the floating rate note component means we’re still comfortable holding hybrids, although they aren’t trading particularly cheap. Then there are tier two securities, like NABPE, which is one of our preferred hybrids.”

However, Likos cautions investors to expect “fair” returns rather than the outperformance of the recent past.

“Hybrids are not cheap right now, they’re more like fair value,” he says. “But we’re ok accumulating strong issuers, floating rate note exposures so you can benefit from the BBSW [bank bill swap rate] pick-up and a consistency of coupon and distribution payments.”

Investors considering the hybrid market still have a wide range of offerings from Australian Securities Exchange-listed hybrid securities to managed funds.

Nearly $44 billion of hybrid securities were listed on the ASX as of February 28. The vast majority are convertible preference shares and capital notes ($42.6 billion), followed by hybrid securities ($925 million) and convertible bonds ($428 million).

Despite the recent bond market slump, Likos expects hybrids to remain popular with Australian investors, particularly retail investors.

“The hybrid market was slow to correct [to higher rates]….but there will continue to be a consistent and regular flow of hybrid securities in the Australian market…and it will continue to be retail focused,” he says.

With term deposits and government bonds still offering low yields, the higher returns on offer from hybrids could still attract income investors capable of tolerating the increased risk.