28 August 2012

ASIC has issued another warning to investors to be careful when subscribing for new hybrid issues, especially those with attractive headline yields. As pointed out in this article in The Australian, not all hybrids have the same risk characteristics.

Once upon a time in the world of corporate capital structures, life was quite simple. Companies issued bonds (debt), which paid regular interest and repaid the principal at maturity. They also issued shares (equity) which may or may not pay dividends and had no repayment date – they are perpetual securities.

Now however there is a continual spectrum between debt and equity with a variety of securities displaying characteristics of both. Most of the securities in this spectrum are called “bonds” or “fixed interest” or “income securities” or “hybrid securities”.

So what is the key difference between debt and equity? Simply put, a debt security has an obligation to make regular interest payments and to repay its principal amount at maturity. Any security that can defer interest payments at the discretion of the issuer without penalty is not debt, no matter what name it is given. It is equity.

So beware those securities that call themselves “subordianted notes” but are really preference shares. If interest payments can be deferred by the issuer without penalty, the security should carry a comensurately higher return for that risk. Buyer beware!