For a free trial go to marcustoday.com.

au
HYBRIDS
Hybrids - an explanation for those who dont know
Hybrids. Are they shares? Well, sort of. You can deal in them like shares and they have some
relationship to shares. But they're not like normal shares.
In short they are like term deposits but issued by companies in the share market rather than the
bond market.
Theyre like term deposits because most of them pay you an interest rate for lending the company
your money and you will be offered your money back after a period of time (redemption). In the
latest ANZ CPS 2 offering for instance you are being offered the opportunity to invest for up to
seven years.
When it comes to paying you interest, each year is divided up into either two or four periods and
they will pay you out two or four times a year. You have to read the PDS (product disclosure
statement) of each individual instrument to know its terms, how much it pays, when and when
you get your money back and how much you get (sometimes you get shares not cash). And like
a term deposit, there may be a sting if you want your money out early.
But its their names which give away the rest of the story. Reset Preference Shares, Converting
Preference Shares, Perpetual Exchangeable Resaleable Listed Securities; sounds like shares to
me and in fact, they are, because in the event the company that issues them goes bust, there is a
pecking order of who gets paid and holders of most hybrids will rank ahead of ordinary
shareholders.
If a company goes bust the creditors get first crack at the assets. Hybrid holders get the next
bite. Ordinary shareholders are last cab off the rank. After all, most hybrids are designed as
preference shares - the holders have preference over ordinary shareholders - and so they rank
above ordinary shares.
PRICE
Hybrids are simply you lending companies money rather than lending the government money and
them paying you a fixed or floating interest rate which is franked or not franked and which is repaid
under certain conditions on a pre-ordained timetable.
The main price drivers are the credit rating of the issuing company and the interest rate they are
prepared to pay but if you hold to maturity you can pretty much ignore the price in between because
youll get a dollar for a dollar at the end.
Whilst some fixed interest professionals tell us that relative to some other more traditional bonds the
recent flood of hybrids have been generally riskier and over-priced, the most recent hybrid issues have
been snapped up by the SMSF industry who dont care about the price. They just feel the yield. The
reason they have over-paid of course is that the cashed up SMSF collective is currently populated by
equity investors that are used to a bit more risk and quite honestly dont give a toss about the
subtleties when safe income investments are in short supply.
The new breed of hybrids are walking off the shelf with their fully franked yields because they have
cleverly targeted the safe income SMSF appetite rather than the bond market intelligentsia who, on
detailed analysis, might baulk at the equity component and throw their hands up at the risk versus
bonds. To many of them, yes, the risk reward ratio versus bonds is out of whack.
WHY HYBRIDS
We added four hybrids to the MT Income Portfolio in January 2014. It was a response to feedback that
the income portfolio should really be a Retirement sleep at night income portfolio and not traded. In
other words it should focus on income not capital growth. OKcapital growth if you can get it, but the
focus is on income and capital preservation at all costs and that means a low risk of capital loss.
Longer term the interest in Hybrids is a response to the very unstable conditions we all experienced
during the GFC as well as the years the market spent stressing about the debt issues in Europe and the
US. It also reflects concerns about the slowdown in China and the impact that would have on
Australian equities prices.
You can find a list of hybrids on the Marcus today website where we list some preferred picks. We hold
four in the MT Income Portfolio but we could easily replace them with others of equal quality and
characteristics. 4 seemed enough.
RISK
Here is a chart showing the huge drop in the CBA PERLS III hybrid issue in the GFC. It fell from $200
to $130.


When it comes to risk in Hybrids basically you have to know this. If there is any risk of the parent
company not paying or being able to pay its dividends and hybrid distributions, the hybrid
will get smashed.
Thats your risk, and it usually happens precipitously. For safe income investors that are not watching
too closely, by the time you find out youre at risk it is almost always too late. But the flip side to this
is that if you are playing conservatively (in the major bank hybrids for instance) they are not going to
go bust and if they do you are going to have a lot more to worry about than your hybrid because
something has gone seriously wrong. By then your house price will have imploded and Australian
would have been overrun by barbarian hordes and the only thing going up will be shotgun and baked
bean prices.
Even during the GFC when hybrids of AMP and Macquarie got nailed, they recovered. In hindsight it
was a huge opportunity that was only exploited by fixed interest experts who recognised the
discrepancy between perceived risk and true risk and made 40% on something that shouldnt have
moved at all.
GOLDEN RULES
The Golden Rules of hybrids are these:
If there is any risk of a GFC style event you will probably get nailed so dont fall for the Itll be
OK in the end, just get out.
Stick to the major company issues. The capital risk is so acute when it does go wrong that you
dont need to play in the smart arse small end of the hybrid market. There arent many of
them anyway.
If we do see a GFC style even and the major bank hybrids are down 40%...buy them!
RETIREMENT PORTFOLIO
We cover Hybrids in our Retirement Portfolio article in which our Retirement Today writer Harold talks
about his portfolio and includes up to 40% in Hybrids.
As his hybrids mature he intends to replace them with more hybrids or new hybrids that may not yield
10 per cent any more but still yield more than term deposits. When it came to hybrid selection he has
played it safe, all his hybrids are in major banks and have a fixed maturity date so he knows that
despite daily fluctuations in price, he will get his money back unless they go bust. On the way he
should get almost double the current term deposit rate. Of course he does have to take on a small
increase in risk but really, the banks going bust? Again, if that happens we'll have more to worry about
than our equity portfolios because the country would have gone to hell in a basket.
QUESTIONS ON HYBRIDS
QUESTION 1 - You suggested hybrids could be a worthwhile investment. I have a very difficult
question for you and that is if American interest rates on their 30 year bonds skyrocket this year and
the Australian dollar was to start dropping towards $.80 and overseas investors started pulling out of
our market in a bigger way, how much would you expect these hybrids to drop in value? Are they likely
to drop in value by 10, 20 or 30% if overseas interest rates rose or are these type of financial
instruments likely to remain in a narrow trading range as they have been for the last few years?

REPLY The four hybrids we suggested yesterday are all floating rate notes so interest rates can rise
and the investor will get the benefitso you should hope rates do rise, you will earn more (as long as
rates ris more than inflation). It is only fixed rate hybrids bonds that fall in value when interest rates
rise. The currency isnt going to matter (to a domestic Australian investor) as long as you dont want to
buy anything priced in another currency. It wont impact on the price of the hybrid anyway. You will
only see 10, 20 or 30% drops if there is a risk of the distributions (dividends) and capital not being
repaid as promised. That is only likely in a GFC 2, but even in GFC 1, the hybrids of AMP and
Macquarie fell over only to recover the whole loss because the fear was worse than the reality. It was a
great opportunity in hindsight.and that was the worst financial backdrop in decades. SO I expect
them to continue to trade in a tight range.

Standing back a moment I might just point out that having concerns about hybrids is rather laughable
to the average equity investor. By their nature, equity investors (as opposed to bond investors) are
very happy to take a bit of a risk to make a capital gain, they live on the risk reward curve. For you to
worry about hybrids when you could be investing in a new IPO or a mid-cap resources stocks is, in
equity terms, Chicken Little stuff. It couldnt get much less risky. Because of the lack of risk of course
you are not going to get much of a capital return if any, your expectations should really be limited to
getting the income as promised. For most equity investors the hybrid risk reward ratio is far far
too safe and boring and because of that most equity investors would never buy hybrids (or bonds)
because they are In it to win it, not just survive it. They would argue that if your risk tolerance is
that low you really shouldnt be in equities at all. So the suggestion that you add hybrids to your
portfolio is for the highly conservative investor (if you can call them that) that is focussed on
how much income they get but do not want volatility, risk or capital gains.

Hope that helps put it in perspective.

QUESTION 2 - Hi Marcus - How do I go about buying Hybrids? Can I buy them on the ASX like shares
or do I contact a specialist? Also can I sell at any time or do I need to wait until maturity date?
Thanks.

REPLY No you do not need a specialist hybrid trader. They are traded on the ASX like a normal
equity, just with a longer code (ANZPA, CBAPA, IAGPC, SUNPC). You will be able to buy them through
any broker, full service or online and often the best way to pick them up is when they are first issued
without paying any commission at all. You can sell anytime as well, before maturity, although no-one
really trades hybrids, they are not volatile enough and the commission negates the returns. Here is an
example of the Depth (price quote) on ANZPA.just like any other share.



QUESTION 3 - I found todays article on Hybrids interesting and relevant as I have an SMSF which
currently predominantly comprises cash deposits, due to the perceived lack of value in equities in the
current market. Id be interested (and presumably other subscribers would be as well) in a discussion
in a future newsletter of the relationship between Hybrids and the companys share price. For
example, does it make sense to invest in Hybrids now with a view to converting them into shares at a
future date when the share price is considered fair value so that in the meantime yield is maximised
with minimal risk, but you are positioned to take advantage of a future falling share price? I apologise
if this has been answered in a previous newsletter.

REPLY I really wouldnt bother using hybrids as a way to get shares Cheap. There is no guarantee
it will work. If they do convert into shares at maturity you will be getting the shares at perhaps a small
discount to the price at maturity but who is to know what the share price will be and whether it is over
or under valued at that point in time. When share prices can move say 1-3% in a day mucking about in
long duration hybrids to finesse the share price is missing the point. Equity investing is about buying
low and selling high and you can do that in shares anytime without having to involve yourself in
hybrids and theyre restrictions and complications. Id simply buy hybrids if you want hybrids for the
hybrid properties (income and low risk) and buy and sell equities independently. It is also worth noting
that whilst you may be trying to time the right moment to buy shares through hybrids in most cases
you will not be able to because you will have to wait until maturity to convert, so the timing is out of
your hands. The bottom line is, if you are trying to time equities trade equities not hybrids. Hope that
helps.
QUESTION 4 Making a loss - If I pay the current market price for a Hybrid which is over $100 but
is converted at the redemption value for $100 does that mean I will make a capital loss on conversion?
What am I missing here?
REPLY - Yes.they only pay back the $100 (say) and if the price you paid is higher than $100 you will
get less back. The higher price is most likely reflecting an improved income payout assumption since
the hybrid was first issued. You are not missing anything. This is why hybrid research quotes yield to
maturity/reset (which takes into account the loss). They are easy to pricejust a function of future
discounted cash flows (distributions) compared to the risk free rate (compared to what you get in
bonds). So a higher price than $100 reflects a superior yield to maturity than bonds. Some brokers do
quote yield to maturity/reset in their research but to do so for floating rates hybrids requires them to
make assumptions about future interest rates. So its all a bit rubbery. With fixed rate hybrids you can
quote yield to maturity/reset but not floating...not without assumptions.

QUESTION 5 Is 40% too much - I am 79. Regarding Hybrids and your recent article, I was
surprised you recommended up to 40% of the portfolio could be invested this way. I currently have
around 10% in 7 hybrids AMPHA, ANZHA,ANZPB. CTXHA, SUNPC,TAHHA, NABHB. Could I do better or
invest more?
REPLY - The 40% hybrids recommendation is a reflection of Member feedback which says I no longer
trust the market, cant afford another GFC (but think its possible), I just want income not capital risk
but I have to be able to do better than term deposit rates. So the 40% is ultra conservative for a
typical equity investor who is used to chasing capital gains by taking risk. The 40% can be dialed down
at your leisure depending on your faith/risk appetite, vigilance, interest in the markets. How
conservative are you? I would say you could easily hold more hybrids rather than equities for a more
stress free investment experience (more golf less newsletters) but then again you may enjoy
watching equities.
QUESTION 6 Margin lending into Hybrids - Great discussion you are having on Hybrids. I
checked my online broker and buying is easy. I would just like to ask, if you see Hybrids also as a fit to
buy for a marginal lending account? I can see that the LVR vary a little bit (65-70% in my case), but in
regards to the return vs. loan interest over a longer period, are there any things to think about in your
view?
REPLY - I always felt that where the whole industry (clients and brokers) go wrong is thinking the
market is for making money rather than looking after money you already own. Id never borrow to
invest. If margin lending you would be buying for an nth of a percent after costs (surely) and you
would be assuming the capital is safe. But come a GFC 2 you will get destroyed. I just wouldnt
bother.but thats mejust dont need to expose the family to a GFC 2. Having said that, if you were
going to margin lend and you are cutting a few percent, then this is the low risk end to do it probably.
QUESTION 7 - What factors affect which Hybrids to buy?
REPLY - Where you think we are in the interest rate cycle. Buy floating if you think rates have
bottomed (which we think they have). Sell fixed rate hybrids (and buy floating) on an interest rate low
(now). Buy shorter term hybrids rather than perpetual if you think interest rates will rise, you will get
more bang for your buck on an interest rate move.

12
th
March 2014