When you purchase a bond, you are providing funds to the issuer, whether it’s a commercial bank or the reserve bank.
The bond issuer is obligated to repay the investor the face value of the bond (corporate bond, bank bond , government bond, or hybrid) on a specified date and to pay regular coupon payments, either quarterly or semi-annually, along the way.
“Hybrid security” is a generic term used to describe security combining elements of debt securities (e.g., bonds) and equity securities (e.g., shares).
Bonds pay either a fixed or floating rate of return until the end date, while Tier 1 hybrids don’t have an end date. The equity element of hybrids increases the risk factor but also means that hybrid securities have a potentially higher yield than bonds.
The higher level of income and attached franking credit benefits of hybrid securities have made them popular with direct investors.
Bank bonds account for around half of all outstanding Australian non-government bonds.
- What are bank bonds, and how do they work?
- Types of bonds
- What are hybrid securities?
- Examples of hybrid securities
- Understanding Tier 1 and Tier 2 bank hybrids
- What is a Tier 1 bank hybrid?
- What is a Tier 2 bank hybrid?
- Benefits of investing in bank hybrid securities
- Risks of investing in bank hybrid securities
- Measuring returns of bank hybrid securities
Face Value – This is the amount a bond returns at the end of the term.
Purchase Price – This is what you paid for the bond or hybrid security, which might be more or less than the face value.
Hybrid security – A debt security: one instrument with features of both debt and the equity market.
Maturity – This is the date on which the face value is repaid.
Issuer – The issuer of a bond or hybrid security (e.g., the Commonwealth Government or a large corporation or bank).
Investor – The buyer.
Coupon rate – A percentage of the face value of a bond, or hybrid, paid from the date of issue until maturity.
Australian Securities Exchange (ASX) – One of the world’s top-10 listed exchange groups.
Tier 1 capital – The primary funding source of the bank, consisting of shareholder’s equity and retained earnings.
Tier 2 capital – Revaluation reserves, general loan-loss reserves, hybrid capital instruments, subordinated term debt, and undisclosed reserves.
What are bank bonds, and how do they work?
Banks, like any other business entity, have liquidity needs. When a bank needs to raise capital, they issue bonds. Investors purchase the bonds, thereby lending the bank money. The bank undertakes to repay the face value, or initial investment amount, on a specific date. The date the face value is paid to investors is known as the “maturity date.”
Bonds are considered a low-risk investment product with several advantages over stocks, including high liquidity in some cases , various term structures, legal protection, and relatively low volatility.
Corporate bonds carry a higher risk than bonds. However, all bonds are subject to certain risks.
These risks are:
- Interest rate risk
- Prepayment risk
- Credit risk
- Liquidity risk
- Reinvestment risk
Types of bonds
There are two types of bonds in Australia:
- Government bond
- Corporate bonds
Each type of bond has its own sellers, buyers, purposes, and risk vs. return levels. There are also securities based on bonds. Financial markets influence bond prices.
What are hybrid securities?
Hybrid securities combine debt and equity characteristics. They represent ownership (like equity) in a company but have fixed payments (like bonds). Since then, different hybrid security structures have evolved.
Hybrid securities allow banks and companies to borrow money from investors. They work in much the same way as debt securities but carry slightly more risk due to the share-like features they offer. However, they are still less risky than ordinary shares.
The higher risk means that there are potentially higher bond yields, but in the same way, there is also more chance of you losing money. The maturity value of hybrid securities usually depends on the price of some other underlying security or set of securities.
Whereas bonds return their full face value (bond price) at maturity, hybrids usually return an amount different from their initial face value. Remember that hybrids are complex investments, so financial advice is vital before investing.
Examples of hybrid securities
In Australia, there are generally two issuers of hybrid securities: banks (bank hybrids) and corporations (corporate hybrids).
Listed companies (on the ASX) or unlisted private companies can issue hybrid securities when they borrow money from investors.
Understanding Tier 1 and Tier 2 bank hybrids
Tier 1 and Tier 2 capital are two types of assets banks hold. Tier 1 capital is a bank’s core capital, which it uses to operate daily. Tier 2 capital is a bank’s additional capital held in reserve.
Banks are required to hold certain percentages of different types of capital on hand.
A Tier 1 bank hybrid security (AT1) ranks lower in the capital structure than Tier 2 bonds but higher than ordinary shares. It also has no fixed maturity date. Tier 1 hybrid securities offer potentially higher returns than bonds or Tier 2 bank hybrids but involve much higher risk.
These types of securities can be converted or written off in the event of a common equity trigger event. For example, if the bank goes into liquidation.
After a certain time, Tier 1 bank hybrids generally convert into ordinary shares. This is a mandatory or scheduled conversion and typically occurs on a fixed date. However, criteria and conditions may vary depending on the security.
Benefits of investing in bank hybrid securities
Bank hybrid securities provide an opportunity for investors to diversify their investment portfolios. Bank hybrids pose a lower risk than ordinary shares and can provide regular and defined revenue in the form of distributions.
Risks of investing in bank hybrid securities
Bank hybrids are complex investments and carry several risks for investors.
Here are some of the risks investors face:
- Distribution may not be paid in certain circumstances.
- Distributions are at a pre-determined rate, so investors don’t benefit from any increase in bank profits.
Measuring returns of bank hybrid securities
There are several ways to measure returns on bank hybrid securities. Here are some of the most common methods:
- Coupon or distribution rate
- Running yield
- Yield to the first call
These measures can be quoted in broker rate sheets or through a financial advisor with access to the relevant information.
Seek advice from your financial advisor when interpreting the data, as the actual calculation method of each measure may differ among sources and could be based on various assumptions.
After reading this article, you should have a better idea of how bank bonds and hybrid securities work.
Whether you choose to invest in ordinary bank bonds, which are slightly safer, or bank hybrid securities, which offer potentially higher returns but pose a higher risk, depends on your personal financial goals.
Whichever option you choose, it’s important to make a properly informed decision by seeking advice from a professional financial advisor.
Disclaimer: Australian Bond Exchange Pty Ltd ACN 605 038 935 AFSL 484453 (ABE). This article is intended to provide general information of an educational nature only. It does not constitute the provision of personal advice and does not take into account your personal objectives, financial situation or needs. Before investing with ABE, you should consider the appropriateness of the investment to your particular financial and taxation situation and consider obtaining independent advice before making an investment. Examples in this article are for illustration purposes only and are not a recommendation to buy, sell or hold a particular investment. ABE makes no representation or guarantee as to the availability of a bond with the characteristics described in this article or that an investment made by you will generate the returns in the illustration. Past performance is not an indication of future performance. Investing with ABE is subject to our Client Services and Custody Agreement Terms and Conditions and Financial Services Guide.