Every now and then we do an educational piece on something investment related. In this article, we will talk about hybrid securities and how to evaluate them. Hybrids are named as such because they have features of both debt and equity securities. Furthermore, they usually rank in-between debt and shares in the hierarchy of a company’s capital structure and therefore they are second in line behind debt-holders for getting paid in the event of the bankruptcy of the company. The debt characteristics of hybrids can make them difficult to evaluate for investors who are used to buying shares however these debt like qualities can actually help in comparing different hybrid securities.
One important consideration for the evaluation of a hybrid security is its yield. Now it just so happens that there is not one single yield measure that can be calculated for a hybrid and it is important to consider the different yield measures. First, there is the distribution rate of the hybrid. This is the amount of the expected yearly distribution relative to the par value of the hybrid. Second, there is the running yield. This is the ratio of the expected yearly distribution relative to the current market price of the hybrid. Finally, there is the yield to maturity. This is the expected annual yield of the hybrid if it was held by the investor until redeemed by the company. The yield to maturity, therefore, takes into account any capital gain or loss that would arise from differences between the buy price of the hybrid and its par value. The following example may help to explain. Consider a hypothetical hybrid security that has a par value of $100, a current market price of $90, a distribution rate of 5% and three years until it is due to be redeemed. Here is the calculation of the three different yield measures.
- The distribution rate of 5% implies a distribution amount of $5 per hybrid per year (5% times $100 par value).
- The running yield is the $5 distribution rate divided by the current market price of $90, giving a running yield of 5.55%
- The yield to maturity is a more complicated calculation but takes into account of the $10 profit that will result from buying the hybrid on the market at $90 and receiving the $100 par value upon maturity of the hybrid. This can be calculated using the excel ‘Rate’ function and in this case gives a yield to maturity of 9%. The yield to maturity is significantly higher than either the distribution rate or the running yield because of the extra $10 profit that is included in this calculation.
For the purpose of comparing hybrid securities, the yield to maturity is probably the most relevant measure because it takes into account all cash flows expected to be received by the investor. Unfortunately, calculation of the yield to maturity isn’t always straightforward as the redemption date of some hybrids is uncertain.
Rivkin calculates the yield to maturity of all of the hybrids on the ASX as the starting point for evaluating the attractiveness of a given security. After further analysis, we pick the most attractive, high yielding hybrids for inclusion in our income portfolio that is designed to give investors a steady stream of distribution income.
