Modern-day hybrids in effect underwrite the dividend and share price performance of the issuer. Photo: Michelle Mossop
The hybrid spruikers are out again, pitching Commonwealth's new PERLS VII Capital Notes offer. At $2.6 billion, it's the biggest hybrid issue so far. Brokers and bankers are clearly confident their clients will lap it up.
Fooling some of the people some of the time can make for a very comfortable living but there are plenty of reasons why you should avoid this offer.
PERLS VII offers a starting return of 5.4 per cent (including franking credits), about 1 per cent above the return from a Government guaranteed five-year term deposit. That's very little margin for error, so you need to be damn sure you'll get your money back. Unfortunately, you can't be.
The modern day hybrid in effect underwrites the dividend and share price performance of the issuer. If Commonwealth's dividend is axed or the share price plummets, so will the value of PERLS VII.
By how much is hard to say, since there's a 'tipping point' effect, but in a financial crisis investors should expect to lose a lot of money.
Some say APRA, the bank regulator, wouldn't allow this to happen but that's to miss the point entirely.
APRA's role is to protect bank depositors, not investors. The regulator has an incentive to see PERLS VII investors lose money in a crisis (by forcing them to convert to ordinary shares) because it protects depositors. Hybrids are designed to be a "sacrificial lamb".
There is speculation that Australia might follow the UK's lead and ban the sale of hybrids to small retail investors. Putting the regulator in a position where they're relying on one group of ordinary investors to lose money so another group doesn't isn't sensible policy.
But it's not just financial crises or APRA that investors in PERLS VII need to worry about. There's plenty of other unlikely but possible events that could cost hybrid investors a packet. For example, in my last article I raised the risk of changes to our franking credit rules.
Any change which limited the ability of pension mode self-managed super funds to have franking credits refunded would be bad news for the PERLS VII price as franking credits make up almost a third of the returns. If self-managed super fund investors were selling en-masse, there's unlikely to be buyers to take up the slack until the price had fallen significantly below the $100 issue price. Investors would be forced to either sell at a loss, or accept a meagre 3.8 per cent cash return (and the risks) for years to come.
Rising interest rates are also a worry as this might cause investors to stop chasing yield (by buying hybrids). Something really ugly, like a serious recession, could see the $2.6 billion invested in PERLS VII vapourised.
Fortunately, the most likely outcome is that nothing too dramatic happens, investors receive their 5.4 per cent and they eventually get back most of their $100 investment eight to 10 years from now.
But before succumbing to your broker's sales pitch, ask yourself this: for such a measly return, is it really worth taking the risk?
Richard Livingston is the managing director of Intelligent Investor Super Advisor, an online service providing advice on superannuation and investing. This article contains general investment advice only (under AFSL 282288).
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