Since the GFC Australian households have become more risk averse. This is evidenced by the allocation in super funds to cash and short-term securities having reached the highest levels in nearly 20 years in 2013.

With the official cash rate at a record low 2.5% (less than inflation) and rates on term deposits having declined substantially, investors are increasingly looking at other fixed income options offering higher yields including hybrids to increase their income. The largest issuers by volume in this market are financial institutions including the banks, which are specifically targeting retail investors who can access tax credits to earn the fully franked gross yield.

With the Australian banking sector in good health and no major crises expected, an allocation to hybrids seems to make sense to yield-hungry investors. What should however not be forgotten is that there is no “free lunch” in investing. Investors are being paid a higher yield because hybrids represent the highest risk fixed income security in a company’s capital structure.

In fact, post GFC new issues by banks have grown increasingly complex, moving from being more debt like to more equity like as APRA has required these securities to have specific loss absorbing terms if the company is in distress. If an investor is allocating to hybrids on the expectation that this portion of their portfolio will offer a) capital stability and b) low correlation to growth assets like equities, the graph below prepared by Macquarie Funds Group “MFG” (see notes on index construction) may provide food for thought.

In essence, while we do not expect another GFC-like crises, investors should consider the implications if there is, and ask themselves whether an expected average absolute return for the listed interest-rate security market of 5.5 – 6.5% p.a. (at the time of writing assuming the RBA remains on hold and credit spreads are broadly range bound), offers sufficient compensation for the risks being taken by investing in hybrids.

Index Methodology
In order to compare the performance across equity, hybrid instruments, subordinated debt and senior debt, MFG constructed equally weighted indices that comprised instruments issued by the big 4 banks, Macquarie and Suncorp.

These four indices were calculated to ensure that coupon or dividend payments do not generate a discontinuity in the time series of index values, with coupons and dividends reinvested in the universe of securities comprising the indices. Indices were rebalanced when a new hybrid was issued. If an issuer had a hybrid instrument in the hybrid index, then the respective instrument was included in the equity, subordinated debt and senior debt indices.