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4 Sep 2023 - Hybrid securities - How risky are they?

By: PURE Asset Management

Hybrid securities - How risky are they?

PURE Asset Management

August 2023

Hybrid securities is a catch-all term and refers to both preference shares and convertible loan notes. They are financial instruments that combine the characteristics of both debt and equity. This article will focus on Convertible Loans, or simply, Convertibles.

These instruments, like traditional debt, pay a rate of interest and have more protections than shares, but they also have the option to be converted into the shares of the Company at some point in the future.

The conversion feature makes them attractive to investors who believe that the value of the Company's shares will increase over time. By holding a Convertible, investors have the potential to participate in the share price appreciation, while also receiving interest while they wait.

The conversion price is typically set at a premium to the current market price of the shares, or it can be based on a discount to a future pricing event, for example an IPO. When the share price rises above the conversion price, the holder can convert into shares and make a profit.

Convertibles can be a way to gain exposure to both income and growth, but like any investment they come with some risks, which could largely be considered to sit between the risk of shares and the risk of traditional debt.

What are the main risks?

Credit risk

The largest risk of a Convertible is credit risk.

Credit risk is the risk of default, if the borrowing Company is unable to pay the interest on the loan, or even payback the original capital, which may be result in a partial or a complete loss of capital.

A key factor influencing the level of risk is the level of security attached to the Convertible. The capital of all companies sits in a capital stack (see below). At the top of the stack is a senior secured loan and at the bottom, equity. The risk of an investment is largely correlated to where the capital sits in the capital stack. Convertibles are typically the top three, so less risky than preference or ordinary shares. (Note that a Company may not have all the layers in the table, but most will have several.)

Senior secured Least risk Hybrid
Secured   Hybrid
Unsecured   Hybrid
Preference shares   Hybrid
Ordinary shares Most risk Equity

In an efficient market, higher levels of credit risk will be associated with higher borrowing costs as the investor wants to receive a higher return for the perceived risk of the investment. In simplistic terms, the higher up the stack, the more other investors' capital there is that would first need to be lost, before the investors above them suffers loss.

In a private market, lenders and borrowers negotiate directly. A savvy lender/private debt manager will attempt to negotiate with the borrower the appropriate terms and conditions, controls, reporting obligations, covenants, and security to ensure the lender has greater influence over the loan terms in an effort to mitigate potential loss risk. Covenants and ongoing borrower reporting requirements are negotiated in order to provide protection and early warning of changing risks.

Liquidity risk

Liquidity risk refers to the inability to sell or trade an investment when needed.

Unlisted hybrid securities are an illiquid investment, and therefore carry the risk that if something goes wrong in the Company, such as a credit risk event, the holder may not be able to liquidate their position in a timely manner.

While hybrid listed on the ASX may offer some liquidity, most are often less liquid than the ordinary shares making them harder to sell.

Conversion risk

When the Convertible converts into shares, the number of shares to be issued to the holder will typically be calculated by dividing the loan amount plus any accumulated interest by a certain share price. This conversion price will often be pre-determined as a fixed price, or it can be priced with a reference to future prevailing share price.

What is not know at the time of investing is what level of profit, or even loss, will result at the conversion event. Some Convertibles have an enforced conversion event, for example at IPO, and in other cases, the Conversion is at the direction of the holder.

If the holder retains the right to choose and elects not to convert, the Company must repay the capital plus any accrued interest. This structure is preferable as it carries less risk of loss on conversion if the Company has performed poorly.

Convertibles vs. traditional debt

Convertibles can be more complex than traditional debt and may have a higher level of return because of the attractive feature of being able to participate in the upside if things go well.

Convertibles vs. equities

Equities represent ownership in a Company, and their value can fluctuate based on a variety of factors such as company performance, industry trends, and overall market conditions. They can be considered riskier than debt because the value of the shares can fluctuate greatly.

Convertibles, on the other hand, pay a fixed or floating rate of interest and also have some of the characteristics of ordinary shares, such as potential for capital appreciation. They tend to be less risky than equities because they typically provide a consistent income stream and also have some or all of the protections intrinsic to debt.

As with any investment, it's important for investors to conduct their own research and consider their own risk tolerance before investing in hybrid securities. It's also important to diversify your portfolio and not to put all of your eggs in one basket.

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