What is... | April 29, 2015

What is a hybrid security?

When investing, it can be tempting to choose a hybrid that on the surface promises better returns. Beware of what lies beneath.

Beauty and the Beast, The Frog Prince, Dr Jekyll and Mr Hyde: tales of shape-shifting have fascinated people for centuries. The key to these stories is often how a creature or person turns out to have a secret life, or be unexpectedly different in some important way.
Financial offerings can be like that too – like one thing in some situations, but behaving differently in others.
A hybrid security, as the name suggests, may be treated like a bond in certain circumstances, and as a share in others. Examples might include such complex financial instruments as convertible bonds.
Hybrids are typically highly complex, detailed and difficult to assess even for the most experienced professional investors.
These unique offerings may look at first glance like bonds because they appear to offer secure, steady, bond-like returns.
This may have a certain charm, especially at a time of low interest rates on savings – but hybrids can also be extremely risky.

You’ve been framed
The appeal can be greater when you see these products have been advertised – or framed – within the pages of a reputable information source – such as a respected media outlet.
It’s so easy to give something more credence than it deserves simply because of the way it is presented, alongside something of recognisable quality or value.
This is even more true when the value of what’s on offer is difficult to calculate.
We can be afraid to miss out. The loss aversion thinking trap can kick in – and we move to avoid the chance of loss, without considering other factors, even though the promised returns are not guaranteed.
A 2015 study by Queensland Behavioural Economics group (QuBE) for the Australian Securities and Investment Commission found that those suffering from overconfidence or an illusion of control are more likely to opt for hybrid securities, even if they do not fully understand them.

Many happy returns?
With hybrids, you may not get a return at all, under certain circumstances.
Investment blogger The Motley Fool explains: “Many hybrids are constructed to have sufficient equity-like behaviour that they don’t count as debt on the balance sheet and remember, equity holders are the last in line in times of trouble.”
Investors in hybrid notes issued by 137-year-old forestry company Gunns lost out when it collapsed in 2012 with massive debts, the Fool points out. The Australian firm decided to invoke a contract clause that allowed its hybrid notes to be converted into a restricted number of ordinary shares that were ultimately worth a lot less.
“When the company got into trouble, it decided it didn’t owe these investors money and wasn’t going to treat them as debtors,” the Fool says. “The reality is they have always had all the equity risk but none of the upside.”

Fairy tale ending?
None of us can foretell the future, and few of us are specialists in finance.
Economist Chris Dillow says we’re all “unavoidably ignorant” when it comes to investing.
“Investing looks horribly complicated. There are thousands of shares and funds to choose from, and it’s impossible to say which are the best given that returns are so unpredictable,” he says.
However, he adds that if we’re tempted to try our luck there are three rules of thumb for navigating a maze of money choices: invest regularly and start soon, diversify in a simple way, and minimise fees and taxes.
Do due diligence on the company making the offer, and work through all the variables. Calculate whether you can cope with a worst-case scenario.
A conservative approach may still backfire, but it may also help you get things right on average – and that’s better than being completely, utterly mistaken, Dillow says.
If you decide to add a hybrid security to your investments, make sure you understand what you’re getting into. Like in the story, you may have to kiss a lot of frogs before you find your prince.
But as Dillow’s advice suggests, when it comes to investments, you shouldn’t have to.

InvestingSharesBondsAsset allocation

eZonomics team
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