Looking for Higher Returns Could Cost You

Remember Michael from our cautionary tale yesterday?

If you don’t you can read about him here.

One of the investments that failed for Michael was priority (or preference) shares. They offered higher returns than regular savings accounts.

Between October 2008 and September 2009, Spanish banks placed 14 billion euros in priority shares among clients and retail investors. They were seeking cheap financing, after the Lehman Brothers collapse, to maintain revenue.

When Spanish banks hit financial trouble, investors like Michael had to share losses with the banks.

Priority shares are a type of — what investors know in Australia as — hybrid shares. That is, they combine parts of debt securities with equity securities.

In Australia, low interest rates are pushing investors to look for higher returns.

Hybrid securities have been gaining ground

Last Wednesday, the Commonwealth Bank of Australia [ASX:CBA] announced they will be offering PERLS X to increase the bank’s capital. PERLS are hybrid securities that pay a margin of 3.40–3.60%, spread over bills.

PERLS is an acronym for Perpetual Exchangeable Resaleable Listed Securities.

The word perpetual should be sending shivers down your spine…more on this below.

CBA is not the only bank issuing these. All big four banks have issued hybrid securities.

According to the Australian Financial Review (AFR), the four major banks had issued $27.58 billion in July last year.

In an interview last year with the AFR, former Australian Securities and Investments Commission (ASIC) chair Greg Medcraft slammed hybrid securities. He said they were a ‘ridiculous’ product for retail investors.

If a bank has any trouble they’re the first line of defence. If you wipe out retail and all those retail investors are superannuation investors you are robbing Peter to pay Paul.

‘You’ve seen already overseas that there were real issues in exercising against them when banks got into trouble.

The UK banned hybrid securities back in 2014. The reason? They were ‘highly complex’ and not appropriate for the mass retail market.

CBA has shrugged off criticisms. CBA’s group treasurer Paolo Tonucci said:

When we talk about [retail], most of that is private banks, not mums and dads. It’s typically reasonably wealthy and sophisticated investors.

‘A lot of the noise about complexity is misplaced – they know these securities and will have substantial investments in other riskier assets.

Yet as ASIC explains on their website, these investments have terms that ‘even experienced investors can find difficult to understand’.

But Medcraft is not the first to warn about hybrid securities.

Back in August 2016, Wayne Byres, chairman of the Australian Prudential Regulation Authority (APRA), told The Australian Financial Review :

Viewing these capital instruments as simply higher-yielding substitutes for vanilla fixed-interest investments, let alone deposits, is something to be counselled against, since from APRA’s perspective holders of these instruments are providing the important first lines of defence that we can call into action, in some instances even ahead of shareholders, to aid an orderly resolution.’

ASIC has also issued a clear warning on bank hybrid securities through MoneySmart (the emphasis is mine):

All new hybrids issued by banks and insurers are designed to be loss absorbing, which means you, not the bank, are at risk of suffering a loss. This protects the bank’s depositors, at the expense of hybrid investors.

If the bank experiences financial difficulty, bank hybrids can be converted into bank shares, which may be worth less than your initial investment, or even written off completely, meaning you could lose all of your capital.

That is, you may be receiving regular high-interest payments, as long as the bank is profitable.

But if the bank runs into trouble, the bank will use hybrid investments to protect savers. 

Hybrids are perpetual. That is, they don’t have a maturity date — even if there are terms specifying when your investment can be repaid or converted into shares. This means that your investment may never be repaid.

This is from ASX on hybrid securities (emphasis mine):

Bank hybrids that meet APRA’s prudential standards to be treated as regulatory capital are classified as either Tier 1 bank hybrids or Tier 2 bank hybrids. Tier 1 bank hybrids do not have a fixed maturity date, and typically convert into ordinary shares on a fixed date assuming certain conversion conditions are met, in a process known as scheduled or mandatory conversion. Tier 2 bank hybrids have a fixed maturity date.

In the event of the bank’s core capital falling below a predetermined level, or the bank becoming non-viable, the bank may be required to convert some or all of its Tier 1 bank hybrids into ordinary shares, with conversion terms likely to result in material losses for the security holder.

Hybrids are very different from saving accounts.

For a start, they are NOT covered by the government guarantee scheme, and the issuer does not guarantee the investment will be repaid.

If the bank runs into trouble, your investment can be turned into shares…or even written off.

Even if you receive shares, you could struggle to find a buyer to recoup your money if the bank is in financial trouble.

This is what happens when you start reaching for yield. High risk does not always equal high reward; it can also mean losing all your money.

Hybrid securities entice you with the prospect of high profitability in a low interest rate environment. Yet they come at a high risk.

You finance the bank and take ALL the risk. There are no guarantees, and it can cost you.

Buyer beware.

Kind regards,

Selva Freigedo,
Editor, Markets & Money

PS: As editor Vern Gowdie so often says, ‘High risk DOES NOT equal a corresponding high return. In some cases HIGH RISK results in complete LOSS OF CAPITAL.

After years of low interest rates and high risk, Vern thinks we are heading for a ‘big one’. That is why he has created a survival guide to protect investors from a massive crash. For more information on his step-by-step guide, click here.

Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain. She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default. Selva now writes from her vantage point here in Australia. She is lead Editor at the daily e-letter Markets & Money. And every week, she goes through each report and research note produced by our global network of trusted advisors to find the best investment opportunities for you in Australia and overseas. She packages these opportunities for you in Global Investor.

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