In our recent review, “How do hybrids fit into investment portfolios” (published June 25), we investigated the characteristics, type and the key drivers of hybrid securities. Thus, we now propose how to construct different portfolios of hybrid securities based on the individual characteristics of listed hybrids and the risk profiles of investors.

In doing so, we suggest that investors should expect to take on higher risks and higher price volatility in order to achieve a higher return. This higher return will be seen in a higher yield over the short term and a higher overall return in the longer term. However, it is likely that a higher risk hybrid portfolio may suffer larger price volatility based on economic or market events which affect sentiment or the so called “risk appetite”.

In the table below, we have structured three different samples of hybrid portfolios according to the risk profile of an investor – “lower risk”, “moderate risk” and “higher risk”. They have been structured such that each hybrid security, at cost, will represent an equal percentage of the portfolio.

Should an investor decide that capital protection is their main consideration, then an investor should select a “lower risk” hybrids portfolio. Lets assume that you have $30,000 to invest, and the structure suggests that you invest $10,000 each in NABHA, PCAPA and WOWHB. The portfolio is then expected to have an average running yield of approximately 6.8% p.a.

Should the “higher risk” portfolio be chosen, it is expected to have an average running yield of approximately 10.1% p.a, whilst the “moderate risk” portfolio is expected to generate an average running yield of 8.4% p.a.

In general, an investor should always consider how much capital risk and/or price volatility they are prepared to take prior to investing. Based on observable historical price volatility an investor should consider whether the higher assumed risk is commensurate with the expected return of the portfolio. At the funds management level at Clime we carry out these analyses on a regular basis.

Samples of Hybrid Securities Portfolios

 

NB:

• For the perpetual hybrids, a time frame of 40 years is utilised to calculate the yield to call. In other words, we assume that they will be called back in 40 years which is a very long time.
• Relative value is based our analytical model of valuing hybrids. It is based on a similar equity multiple valuation approach used in MyClime for valuing stocks.
  • (a) Small Discount (or premium) ~±2.5%
  • (b) Fair ~±1.0%
  • (c) Discount (or premium) ~ ±2.5% to ± 5.0%
  • (d) Big Discount (or big premium) ~ ±5.0% to ±10.0%
  • (e) Very Big Discount (or very big premium) ~<±10.0%

* 1 year historical volatilities for the hybrids were calculates and use to set these parameters.

NABHA

NABHA is the income and security notes of National Australia Bank. This is a liquid hybrid security and probably the most commonly held. They trade at a margin of 1.25% over the 90 day BBSW rate and dividends are paid quarterly during mid February, May, August and November each year. The running yield is approximately 7.7% p.a based on a current acquisition price of $78.40.

PCAPA

PCAPA is the Commonwealth Bank’s PEARL III (Perpetual Exchange Repurchase Listed Shares). The margin is 1.05% and the next reset / step up date is on April 2016, more than 5.5 years away. You may note that while the running yield is lower than the NABHA at approximately 6.8%, the yield to call (or reset date) is about 9.0% as PCAPA is trading well below their face value of $200 (or close to a 10% discount). Thus, when that return is annualised for the potential capital gain to the call / step up date, the total return is close to 9.0%. For an investor, the key question is whether they are prepared to accept a lower running yield of about 6.8% in the next 5.5 years. However, as the call / reset date draws nearer, there is a strong probability that you will realise the additional gain through price appreciation of the PCAPA back to the face value of the stock.

Naturally, there is a possibility that the bank may not call back and reissue, and opt for a step up of 1%. However, to protect the bank’s reputation, it is our view that this is unlikely to occur. Even if the bank is to forsake its reputation and opt for a step up, the running yield post step up would have gone up to 7.8% pa.

PCAPA distributes the dividend in early January, April, July and October of each year.

WOWHB

WOWHB is Woolworths Limited’s unsecured floating rate subordinate perpetual notes. The margin is 1.1% and the next reset / step up date is mid September 2011 which is just over 15 months away.

Similar to PCAPA, while the running yield is low at approx. 6%, the yield to call / step up is actually approximately 8.0%. It is our view that it is highly likely that WOW will call back their notes and will reissue another rather than pay the additional 2.0% step up margin on top of the current 1.1%. This is a similar argument to that concerning PCAPA.

AAZPB

AAZPB is the preference share of Australand Property Trust which is part of the Australand Property Group (ALZ). They are currently trading at 4.8% over the 90 day BBSW rate, implying that the floating running yield currently is approximately 11%. Given that the underlying company has recapitalised and the gearing is now in the mid to high 20%, it is our view that AAZPB hybrid will behave more like debt and continue to pay a high yield income every quarter around mid January, April, July and October until they opt to have them redeemed.

MXUPA

MXUPA is the preference share of Multiplex Brookfield Limited. Brookfield Asset Management is a global asset manager focused on property, renewable power and infrastructure asset with over C$100 billion under management. Their senior debt is of investment grade. MXUPA is currently trading at 3.90% margin over the 90 day BBSW rate, implying that the floating running yield currently is approximately 11.28%.

MXUPA pays their distribution around mid January, April, July and October each year.

We note that most of the hybrid securities in the portfolio listed above have rallied over the past week; we would caution investors to always be patient and try to acquire the securities either at fair value or discount by using the commentary on the relative valuation column in the table as a guide. When you are making that decision, also note that price of the hybrids continue to accrue interest or dividend until the interest or dividend has gone ex-entitlement.