Hybrid securities – How do the conversion conditions impact risk?
01 Jul 2015
By Shadforth Financial Group
With the recent fall in interest rates offered on term deposits, investors are looking for alternative investments to boost their income. Hybrid securities are an increasingly popular method of achieving fixed interest exposure, however it is important that investors understand the key terms before investing.
Hybrid securities earn their name from the fact that they possess some characteristics of a listed share and some characteristics of a fixed interest investment. Most hybrids are listed on the ASX and can be bought and sold like any other listed investment. They pay interest on a regular basis, either half yearly or quarterly, and are usually a lower risk investment than shares.
One of the most common types of hybrids issued in recent years is called 'Mandatory Conversion' securities. These securities are issued by financial institutions and are the main structure used by the major banks for new issues. In order to qualify as equity on the issuer's balance sheet, APRA requires new issues to include key terms.
Mandatory conversion securities normally have a term of 7-10 years with the option to be redeemed at the issuing company's discretion two years before this date, subject to APRA approval. If certain conditions are not met at the mandatory conversion date, the securities will effectively become perpetual securities, with the mandatory conversion conditions re-tested on each dividend date.
Mandatory conversion conditions In order for mandatory conversion securities to convert, they need to meet three mandatory conversion conditions.
- The first mandatory conversion condition is satisfied when the volume weighted average price (VWAP) on the 25th business day before the mandatory conversion date is greater than 56 per cent of the issue date VWAP.
- The second mandatory conversion condition is satisfied when the VWAP of the 20 days preceding the mandatory conversion date exceeds 50.51 per cent of the issue date VWAP.
- The third mandatory conversion condition is that the ordinary shares are trading at the time of the mandatory conversion date.
In order to reduce the potential impact from conversion, APRA has imposed a maximum conversion number, which is calculated as the face value (normally $100) divided by 50 per cent of the VWAP. This effectively means that the security holder could receive less than $100 worth of ordinary shares upon conversion if the issuing company's share price is trading below 50 per cent of the issue date VWAP. However, if the issuing company's share price was below 50 per cent of the issue date VWAP, they would not meet the first conversion condition, limiting the downside risk. It is possible to convert into less than $100 worth of ordinary shares if the share price drops sharply below 50 percent of the issue date VWAP in the days just before conversion.
Capital trigger events
The fallout from the GFC has seen APRA require two further conversion conditions to be included in hybrid securities. The two capital triggers are:
- Common equity tier 1 capital falls below 5.125%
- APRA deems the financial institution non-viable
The trigger events require conversion of the hybrid security into ordinary shares, providing an immediate injection of common equity tier 1 capital.
If either of the above capital triggers are met, the security will convert into ordinary shares without testing of the mandatory conversion conditions. The maximum number of shares that the securities can be converted into is calculated as the face value divided by 20 per cent of the issue date VWAP. This could mean security holders lose capital if conversion occurs when the ordinary share price is trading below 20 per cent of the issue date VWAP.
Volume weighted average price
When reviewing hybrids for inclusion in a portfolio, a number of factors need to be taken into account, including the VWAP of the company's shares at the time the hybrid is issued. The issue date VWAP is not often discussed, but is a critical consideration in assessing a hybrid security.
The table shows the VWAP at the time of issue, as well as the share price decline required to breach the first mandatory conversion condition (as discussed previously).
As can be seen in the table, most securities would need a significant 40 per cent plus fall in the issuing company's share price before being in danger of failing the first conversion condition. This reduces the risk of investing in a mandatory conversion security. Please note that there are other risks to investing in hybrid securities. For further information on hybrid securities, please contact your financial adviser.