Morningstar has responded to outgoing ASIC chair Greg Medcraft’s comments about hybrid securities last week, countering that his “blanket statement” was “excessive”.
In an interview in the Australian Financial Review, Medcraft said hybrids were “ridiculous” product for retail investors.
“If a bank has any trouble they’re the first line of defence,” Medcraft said.
John Likos, Morningstar’s senior credit analyst, says the research house’s view is that hybrid securities are not substitutes for fixed income securities or term deposits.
“We believe they should be treated as a separate asset class with their own asset allocation. They should only be the domain of the medium to high risk investor as art of a diversified portfolio.”
They are not for the low risk investors whose primary concern is the preservation of capital.
What makes hybrids different is that they have the features of debt and equity. Basel III compliant hybrids issued by financial institutions (mainly the big banks) are closer to equity than debt due to certain features in their terms and conditions.
When certain trigger events occur, the hybrid securities may convert to equity.
“Investors need to understand that they are taking on equity-type risk for a bond-like return,” Likos says
Hybrids have been in the news this year. Standard & Poor’s downgraded big bank hybrids in May, dropping them below investment grade. And in June Europe’s Single Resolution Board cancelled all the shares and hybrids of Spain’s Banco Popular in response to the bank’s failure.
Medcraft said that hybrids have been banned from sale to retail investors in some markets, such as the United Kingdom.
“However, hybrid securities have different characteristics in different markets,” Likos says.
For example, UK hybrids are more like perpetual instruments, whereas Australian hybrids have a scheduled conversion date when the securities will convert into equity if certain conditions are met.
Australian bank hybrids contain dividend stoppers, which are not permitted under UK regulations.
UK bank hybrids can have higher capital conversion triggers, relative to Australian bank hybrids. Medcraft was not comparing apples with apples.
“It should be pointed out that Australia’s major banks remain among the strongest in the world, with regards to their financial and business risk profiles,” Likos says.
“Medcraft made the point that if a bank has any trouble hybrids would be the first line of defence.
“Actually, shareholders would be the first line of defence, followed by hybrid security holders.
“In the recent resolution following the failure of Spain’s Banco Popular, a non-viability event led to the complete write-down of equity and hybrid securities simultaneously. Yet this is no reason to avoid either equity or hybrid securities.”
Likos says: “Why did he wait he was on his way out to hammer this message home? We would have liked ASIC to be more vocal from a hybrid education perspective.”