Recently ANZ provided an offer to its investors about a new hybrid security called Capital Notes 3. With margins between 3.60% and 3.80% above the bank bill rate these instruments could be considered enticing when compared to current term deposit rates. However the attractiveness of a hybrid security investment needs to be weighed up against the terms on which they’re offered.

So why do banks issue hybrids?

Under the Australian Prudential Standards issued by APRA, banks are required to have sufficient capital to protect depositors should the bank become financially unviable. The idea being that these capital buffers will be used to pay off the bank’s losses, which helps to shield retail customers. Recently these capital buffers have been increased and to meet these higher capital requirements banks need to either issue new shares or issue instruments that are capable of being counted as regulatory capital. As such banks, including ANZ, have issued new hybrid securities with terms designed to ensure that they are included in the banks’ capital buffer.

When a bank comes under financial stress a larger capital buffer may be welcome news to banks retail customers. However, its unlikely that hybrid security investors will share this view when they discover that their investments are at risk. There is a real possibility that hybrid security investors may not be aware of these risks as ASIC estimate around half of these investors have not received financial advice before making their investment decision. These investors could be in for a real shock during the next financial crisis.

The fact that hybrid securities are used to bolster a bank’s capital buffer explains why they contain some pretty interesting terms. For example:

• The interest payments of hybrid securities are not guaranteed and missed payments do not accumulate.
• Banks cannot guarantee your investment will be repaid and the securities are not covered by the Government guarantee nor secured by a mortgage or security over any asset.
• Hybrid security investors are second last in line to receive their investment back (the last being shareholders).

Investors also need to be wary of ‘mandatory conversion’, which is where the hybrid security investment is converted into ordinary shares at a set date or upon regulatory approval.

Some hybrid securities are perpetual. This means that there is a possibility that an investor will never actually see their initial investment returned to them. Additionally, if the bank experiences financial difficulty, the bank may be required to convert the hybrid securities into ordinary shares or write them off completely. If this were to occur an investor would face the possibility of losing part or the whole of their investment.

Taking all these factors into consideration, hybrid investments have a risk profile similar to ordinary shares, with limited and possibly discretionary returns. The real question regarding the ANZ Capital Notes 3 is whether the approximately 3.6% margin above a comparative term deposit is worth the increased risk. Investors should seek frank financial advice about any possible hybrid security investment before making a decision.