What is a hybrid security?
A hybrid security in the simplest terms is just what it sounds like, a hybrid investment that combines elements of different securities.
These financial instruments have elements of debt securities and equity securities.
What is a debt security?
A debt security is another term for a fixed income investment.
Debt securities include government (treasury) bonds, corporate bonds, municipal bonds (US securities), treasury bills, debentures and certificates of deposit (CDs).
Known for their relative stability and predictable income streams, these types of financial instruments represent a debt relationship between a creditor (investor) and a debtor (issuer).
Debt securities are created when an investor loans money to an issuer (for example the government, a corporation or a bank), and in return receives periodic fixed rate interest payments (coupons), with the principal amount repaid at the maturity date.
What is an equity security?
An equity security is different to a debt security, as these financial instruments do not represent a creditor-debtor relationship. Instead, equities (also called stocks/shares) provide investors with ownership in the issuing company in the form of shares.
Unlike debt securities, equity securities are subject to higher risk as they are subject to fluctuations in the market, geopolitical issues, industry trends and investor sentiment.
Due to the high risk associated with equity securities, investing in these types of securities gives the investor a claim on the assets, earnings and future profits of the company, as well as the ability to vote on certain company matters, relative to the percentage of ownership.
Equities are typically categorised as either common or preferred.
- Common stocks are, as the name suggests, the common form of stocks in a company, and often come with voting rights.
- Preferred stocks embody both the characteristics of debt and equity securities. The fixed dividend payments are like coupon payments, however with preferred stocks the investor also has ownership in the entity which provides capital appreciation opportunities.
What’s important to note about preferred stocks is that features and benefits vary greatly between issuers and entities, so you should speak with an investment adviser before you make any decisions.
What are some examples of Hybrid Securities?
In the Australian market, hybrid securities are generally issued by banks (bank hybrids) or corporations (corporate hybrids).
Corporate Hybrid Securities
Corporate hybrid securities are those issued by corporations that borrow money from smaller investors. The company issuing the security can be either a listed company (on the ASX) or an unlisted private company.
Bank Hybrid Securities
Bank hybrid securities must meet APRA’s strict regulatory requirements in order to be considered “regulatory capital”. These types of securities are classified as either Tier 1 or Tier 2 bank hybrids.
According to the ASX, the most complex hybrid securities are those issued by the major banks, each with varying terms, that constitute the bulk of hybrid issuance in Australia.
Under the Basel III global banking regulatory framework implemented in 2017 by APRA, bank hybrids are classified as either Additional Tier 1 (AT1) or Tier 2 capital.
What is a Tier 1 (AT1) Bank Hybrid?
A Tier 1 bank hybrid security is one that does not have a fixed maturity date and is ranked lower in the capital structure than Tier 2 bonds, but above ordinary shares. These types of securities offer potentially higher returns; however, they involve a much higher risk.
In the event of a common equity trigger event (for example if the company goes into liquidation) these types of investments can be written off or converted.
Tier 1 bank hybrids also generally convert after a certain time into ordinary shares, in what is known as scheduled or mandatory conversion. This typically occurs on a fixed date, but conditions and criteria vary depending upon the security.
What is a Tier 2 Bank Hybrid?
A Tier 2 bank hybrid security operates in a similar fashion to a bond, as it will always have a fixed maturity date. This date is typically around ten years from the issue date.
Tier 2 hybrid securities are preferred by the Australian Bond Exchange, as they are seen as a less risky investment in comparison to the AT1 bank hybrids.
Tier 2 bank hybrid securities sit above ordinary shares, AT1 (Tier 1) hybrids and Tier 1 capital in the capital structure.
Speak to an adviser today to find out the current yields of our Tier 2 Bank Hybrids.
What are the main differences between Tier 1 and Tier 2 Bank Hybrids?
| Tier 1 Bank Hybrid (AT1) | Tier 2 Bank Hybrid | |
| Payment Discretion | Banks have discretion in making coupon payments | Banks do not have discretion in making coupon payments |
| Maturity Date | No Maturity Date | Fixed Maturity Date |
| Seniority | Above ordinary shares | Above ordinary shares and AT1 |
| Franking | Yes | No |
| Missed Payments | Do not accumulate as debt | Accumulate as debt |
| Common Equity Trigger Event | The investment may be converted or written off | The investment will not be converted or written off |
What are the main similarities between Tier 1 and Tier 2 Bank Hybrids?
| Tier 1 Bank Hybrid (AT1) | Tier 2 Bank Hybrid | |
| Payment Frequency | Periodically | Periodically |
| Non-Viability Trigger Event | The investment may be converted or written off | The investment may be converted or written off |
