ASIC today urged consumers to ensure they understand the conditions and risks of hybrid securities and unsecured notes before committing their money.

With considerable volatility in equity markets, many investors are looking for alternative investments, including debt and fixed interest securities. However, some of these alternatives need close scrutiny before the decision to invest is made.

ASIC Chairman Greg Medcraft said: ‘Retail investors may be attracted by the interest rates offered by household name companies and trusted brands, but hybrid securities should not be confused with government bonds or ‘vanilla’ corporate debt. In some cases investors are taking on equity-like risks but only receiving bond-like returns.

‘Investors need to understand the conditions of these offers, such as terms and conditions that allow the issuer to exit the deal or suspend interest payments, and long term maturity dates of several decades. We want to ensure consumers are fully informed before they invest,’ Mr Medcraft said.

Consumer tips

ASIC advises consumers and retail investors who are thinking about investing in a corporate hybrid security to compare offers, read and understand prospectuses, and pay particular attention to the risks.

Most hybrid securities are likely to be sold or recommended to consumers by brokers and financial advisers. ASIC expects these gatekeepers to clearly explain the features and risks of the investments to their clients. Below are five important issues that prospective investors should make sure their broker or adviser explains:

1. What are the risks of investing in this hybrid security?

2. Will the returns offered adequately compensate me for the investment risks?

3. How does the interest rate compare with other investments on a 'risk adjusted' basis? Can other less complex, risky or long-term investments provide a similar or better return?

4. Will this product help the investor achieve their personal goals and objectives, and does it suit their investment timeframe and risk profile?

5. Can investors exit the investment if their circumstances change?

Consumers should always make sure their adviser is licensed to provide financial advice, and get personal advice in writing (a Statement of Advice).

For information about other types of fixed interest investments and to download ASIC’s guide to investing in corporate bonds, visit www.moneysmart.gov.au.

Background

Hybrid securities are one way for companies to borrow money from investors, while paying interest in return. They blend some of the features of debt and equity (shares), and can often be traded on a secondary market such as the ASX. However, hybrid securities have higher risks than most types of corporate bonds. While the conditions, timeframe, risks and interest rates (coupons) of each hybrid offer differ, some recent offers have particularly complex features and risks, including:

• Market price volatility: like company shares, the market price of listed hybrid securities may fall below the price that the investor originally paid, if the company suspends or defers interest payments, or if its performance or prospects decline. Relatively small changes in credit spreads can have a big impact on the market price of long-term hybrid investments. For example, using a simple calculation for an investment with 40 years until maturity, paying 8% per annum, a change in credit spreads from 8% to 9% could see the market value of the hybrid reduce by 11% overnight. [1]

• Subordinated ranking: hybrid securities are generally unsecured, meaning that repayment is not secured by a mortgage or security over any asset. If the company issuing the hybrid securities becomes insolvent, hybrid investors generally rank behind senior bondholders and subordinated bondholders. If a company fails, hybrid investors have to line up behind these creditors and bondholders in the queue for their money.

• Deferral of interest payments: some offers allow the company, at its own discretion, to suspend interest payments for a period of time. While the interest owing may be cumulative (meaning it should be compounded and repaid to investors later), this could leave investors temporarily out of pocket. The security's market price may also be damaged by the decision to hold back interest payments.

• Early termination: some hybrid offers allow the company to terminate or 'buy back' the investment early (similar to the issuer having a call option), but do not give that same right to investors.

• Extremely long timeframes: while trading the security on a secondary market such as the ASX may offer investors a way to exit the investment (assuming the market is liquid and there is demand for the securities), some hybrids have investment terms lasting several decades. For example, with a 60 year term, a 40 year old investing today would need to live to 100 to see their investment mature. Furthermore, the risk of a company defaulting on its obligations, or eventually running into financial difficulties, increases over the long-term. Investors in some hybrid securities take on these unpredictable long-term business risks.

Note 1: This simple calculation assumes no time value of money.