Q: Should a SMSF have hybrids in their portfolio instead of term deposits?

A: Hybrid investments are securities that have debt and equity features. Generally they offer a semi annual coupon (interest) payment and potential for convertibility to the underlying issuers shares at a predetermined time, at the discretion of the issuer.

The attraction of hybrids is that they often will pay a higher interest rate than conventional fixed interest investments such as Term Deposits (generally a consistent margin over the Bank Bill Swap Rate, depending on the credit worthiness of the issue). However, the key difference is that the value of the Hybrid is generally heavily aligned to the performance of the underlying issuer stock (and hence investors will be exposed to a relatively higher level of Capital volatility compared to investing in a Term Deposit.

Due to the above, the investor is taking on a variety of equity like risks with Hybrids which they would not be taking on through investing in a Term Deposit, whose main risk is the bank being solvent through the term. Whilst Term Deposits can be cashed with the bank at full value with a penalty on interest, Hybrids need to be sold on market and the price could vary dramatically from the face value.

A quality Hybrid investment can be a very important mechanism for an SMSF to generate strong yield with potential for capital growth (if bought on market at a discount to face value).

For companies issuing hybrids, they are an attractive mechanism to borrow funds (at a discount to borrowing from Financial Institutions), to finance the business and afford them the flexibility to convert to shareholder equity if so required.

The decision whether to invest in either Term Deposits or Hybrids will be based on your time frame to invest, the issuer’s credit worthiness, the structure of the note and appetite for the above mentioned risks.

This article was published in The Australian on 26 November 2011. A direct link to the article can be found here.

If you have a question you would like Andrew to answer, you can go here and click on the “Your Questions” section.