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Analyst report
In this climate be careful of what shares you buy
April 2, 2008
Brendon Lau, ShareAnalysis
Hybrids have been rocked by the turmoil gripping our share market and the volatility is likely to hound hybrids in the near term. However, in a jittery market such as this, some hybrids may be a better option for investors compared to investing in the underlying shares.
There are a few reasons for this. Firstly, many hybrids are usually not as volatile as their underlying shares and would be easier on investors' stomachs. Secondly, hybrids tend to have a higher yield than the underlying shares and some may even carry franking credits.
Lastly, hybrid distributions are generally more stable because a company cannot cut these the same way it may slash dividends when facing hard times. Hybrid investors also normally rank above shareholders in the event the company is liquidated.
Thus, if you believe in the longer-term prospects of a company but are worried about its share-price performance in the short run, hybrids could be the answer, as investors may have the opportunity to convert the company's hybrids into ordinary shares at a discount under certain circumstances. However, not all hybrids can be converted to equity and often the conversion is at the discretion of the company. Also, there are various types of hybrids and not all companies issue them (see our newsletter dated 14/11/07 for details).
However, the performance of many hybrids since the start of the sub-prime contagion has left some investors feeling unnerved. Because hybrids are often regarded as debt, they are affected by the tremors rocking global debt markets. Investors now demand a higher risk premium, which has led to a sell-down in hybrids, so that corresponding yields would rise enough to appease nervous investors (price and yield move in opposite directions).
Linked to the issue of risk premiums is the credit rating of the hybrid issuer. In this climate where credit spreads are sharply widening, even a hint of a possible downgrade by a ratings agency could trigger a harsh sell-down of a company's bonds and hybrids. Meanwhile, some investors have withdrawn altogether from hybrids since the near collapse of several high-profile companies, as the focus changed from "the return on capital" to "the return of capital".
The latest debacle with US investment bank Bear Stearns is certainly adding to this climate of fear, particularly in the financial sector. As hybrids are relatively thinly traded, waning investor interest can have a big impact on volatility.
This has led a reader to ask us why some companies do not take this opportunity to redeem downtrodden hybrids. This is probably because some do not have the cash, while others do not have a financial incentive due to the rising cost of debt and difficulty in raising capital. Moreover, companies have to pay the face value of the hybrids in order to redeem them, not market value.
There are other reasons why some hybrids have not performed to expectations. Some sectors, such as mining and energy, have outperformed over the last several months and the perceived upside in these shares is far more attractive than their respective hybrids. Santos (STO) and its hybrid (STOPB) is an example. Then there is the issue of rising interest rates. As rates rise, the value of fixed-income hybrids declines. This is why we are biased towards floating-rate hybrids.
Two hybrids we like to highlight are Toll Holdings Toll RPS (TOLPA) and Dyno Nobel SPS (DYNPA).
TOLPA is an equity-linked hybrid that has a high level of optionality and we see it trading as an equity instrument. For investors looking for an entry point into TOL, TOLPA pays a higher yield (fully franked) and provides equity exposure. Given the risks around TOL, it also has less downside risk than a direct investment in TOL. TOLPA has a grossed up yield-to-maturity (YTM) of 6.53% and we have a BUY on the hybrid.
DYNPA is a floating-rate hybrid with unfranked distributions. Although we have a HOLD on the security, the hybrid could present a takeover arbitrage. If Incitec Pivot's (IPL) bid for DXL is successful, it would trigger a change of control event for DYNPA noteholders, in which noteholders are eligible for 115% of the face value ($115) plus any accrued interest.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
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Economics: Labour costs up significantly: survey
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Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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