Preference shares, more commonly known as hybrids in Australia, have become a staple in the investment diet for many retail investors and SMSFs. When economic times are good and companies are doing well, preference shares can provide steady dividends that are usually 1-3% higher than term deposits. However, as the tip of an iceberg warns of the substantial danger below the surface, the structure of hybrids and their performance in the global financial crisis both point to the risk of a shipwreck.
An age-old warning
Whilst this article mainly discusses the relatively recent experience of Australian investors with preference shares, the warnings on these securities date back to at least 1949 when Benjamin Graham wrote the first edition of his classic book The Intelligent Investor. Benjamin Graham is often referred to as ‘the father of value investing’ and the mentor of Warren Buffett, who said The Intelligent Investor is “by far the best book on investing ever written”. In the book Graham writes about the structure of preference shares:
“Really good preferred securities can and do exist, but they are good in spite of their investment form, which is an inherently bad one … the preferred holder lacks both the legal claim of the bondholder and the profit possibilities of the common shareholder.”
He goes on to note the reasons why investors buy preference shares:
“Many investors buy securities of this kind because they need income and cannot get along with the meagre returns offered by top grade (investment grade) issuers. Experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate safety merely because the yield is attractive.”
On when to buy preference shares, Graham argues:
“Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity ... in other words, they should be bought on bargain basis or not at all.”
To help put these arguments into context, a break-down of the key negative features of hybrid shares follows with Australian examples.
Hybrids don’t have equity control rights
In Australia, if investors holding more than 5% of ordinary shares object to the current management or Board of a company they have a right to call for an extraordinary general meeting. The dissenting shareholder group can then propose to change the current directors with a view to new directors changing the overall direction of the company. Hybrid holders have no such rights even when their dividends stop, providing that dividends to ordinary equity have also ceased.
Hybrids don’t have covenant protections like loans or bonds
When a company fails to pay interest on its bonds or loans without prior permission from the lenders, it has contractually defaulted. This effectively hands control of the future of the company over to its lenders, which may ultimately result in insolvency with the Board formally handing its powers over to external administrators. Hybrid holders have no such contractual rights when their dividends are not paid. Their payments are at the full discretion of the Board and are also non-cumulative, meaning that a missed payment is forever lost. Whilst having no dividends might be an acceptable outcome for holders of ordinary equity who can also participate in capital growth, hybrid holders typically invest for regular income and get little or no benefit from the increasing equity value of a company. Holders of hybrids ELDPA (issued by Elders) and PXUPA (issued by Paperlinx) would be well aware of their lack of equity or debt control mechanisms, even though they haven’t received any dividends for many years.
Hybrids have no protections to stop the issuer from becoming excessively leveraged if earnings decline or if the company chooses to issue large amounts of senior ranking debt. Excessive gearing increases the risk that a company will switch off dividends to ordinary and hybrid holders for many years in order to reduce a substantial debt load.
Hybrids are extended in the bad times and redeemed in the good times
Whilst the Australian experience with preference shares is much shorter than the US that Graham wrote about, investors here have experienced the same negative outcomes stemming from not having a maturity date. Many investors discovered in the last decade that step-ups don’t guarantee redemption at their expected call date, with 12 widely-held securities (AAZPB, BENHB, ELDPA, MBLHB, MXUPA, NABHA, NFNG, PXUPA, RHCPA, SBKHB, SVWPA and TPAPA) still outstanding today that have gone past their expected call dates. Loans and bonds at these companies matured during the financial crisis, with new debt issued at significantly higher margins. Preference shareholders are still stuck with the pre-crisis margin and step-up levels.
The opposite side of giving the issuer control over the timing of redemption is now starting to become evident. AAZPB and TPAPA are likely to be redeemed in the second half of 2014. Another potential candidate for redemption is GMPPA, as Goodman is likely to be able to replace the preference shares with cheaper senior debt. GMPPA currently trades above $100 reflecting the relatively attractive returns in the eyes of the market. Current holders are at risk of seeing that premium disappear if the company chooses to redeem, as happened with the price drop of HLNG and HLNGA.
The key issue linking AAZPB, TPAPA and GMPPA is that investors who bought in pre-crisis would have much rather been redeemed during the GFC as replacement securities offered better value then.
Hybrids can convert to equity at the worst times
Most ASX-listed hybrids contain the right for the issuer to convert the securities to ordinary equity at specific times, most likely when the company is in financial difficulty and when ordinary equity is least desirable. For example, holders of Willmott’s WFLPA in 2009 were offered the opportunity to exchange into ordinary equity worth 22.9% less than the issue price of the hybrids. In 2010, Willmott defaulted on its debts with the ordinary equity and hybrids both wiped out.
Bank hybrids are now issued with a standard clause that they will automatically convert to equity if the Common Equity Tier One capital ratio falls below 5.125%. If this point is reached, the bank will have recorded substantial losses on its loans and shareholders are likely to question whether the bank will continue to survive. The prospect of a large scale dilution of ordinary equity will put additional downward pressure on the equity price. It may fall further still if hybrids are compulsorily converted and many respond by selling their newly-acquired equity as quickly as possible.
Recent vintage bank hybrids also contain a maximum conversion ratio limiting the number of ordinary shares that can be received in a conversion process. This means a hybrid shareholder can receive shares worth substantially less than the $100 issue price.
Hybrids have much higher drawdowns than bonds
The experience of many Australian investors during the financial crisis aligns with the patterns of preference share trading identified by Benjamin Graham. The graph below compares the ASX accumulation index, the Elstree Hybrid Index (an index that tracks a broad mix of ASX listed hybrids) and the S&P/ASX Corporate Bond Index using the data covering the seven year period from 2007 to 2013. This is an ‘apples with apples’ comparison as each index includes both capital and income return components. It shows a peak to trough fall of 47.2% for the equity index and 26.6% for the hybrid index, whilst the bond index fell by only 0.8%. The hybrid index did recover its losses much faster than the equity index taking 29 months compared to 71 months to return to the pre-crisis peaks, but bonds again proved to be far lower risk taking only 8 months.
The hybrid index may substantially understate the volatility many Australian investors actually experienced over the seven years, as some hybrid funds suffered peak to trough falls of approximately 40%. Ten securities defaulted and suffered a complete loss of capital whilst both Elders and Paperlinx still trade below 50% of the issue price and have not paid dividends for several years.
Conclusion
In the current times of low interest rates and low economic growth, many Australian investors are building their exposure to hybrids unaware of the risks they are taking.
Benjamin Graham warned of many of the above problems as far back as 1949. Investors then and still today chase yield in bull markets, sacrificing protection measures like covenants in the process. Value investors following Graham’s advice will take advantage of the current low yields on Australian hybrids to sell down their positions and realise substantial capital gains. If Graham’s comments on the cyclicality of hybrids again prove to be true, then they may once again be available at bargain basement prices.
Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.