Comparing Floating Rate Notes and Hybrids
Although Floating Rate Notes and Hybrids may seem similar, there are significant differences between the two. We summarise 10 key differences between these instruments and highlight the impact they can have on investors’ portfolios and how they can influence the potential outcomes an investor can be exposed to.
Floating Rate Notes (FRNs) and hybrid securities are both classified as segments of the broader Corporate Credit and Fixed Income universe. Both are used by corporations to raise capital to fund their operations. They both produce income that is paid on a regular basis (usually quarterly) and, in Australia, there is significant crossover between the issuers in each of these segments – mainly local banks. For these reasons, it may be difficult for investors to appreciate the significant differences between the two types of instruments.
To help investors make a more informed choice between the two, we have summarised 10 key differences between the instruments. One headline difference, that many investors may already be aware of, is that hybrids tend to generate higher income than FRNs. The higher income is because hybrids have a higher risk level due to them being more equity-like than FRNs. While this difference in structure may seem like a minor detail, below we show how this influences the potential outcomes investors can be exposed to. We have also included some charts to highlight the impact these different instruments can have on investors’ portfolios.
1. Seniority – FRNs are amongst the highest ranking capital (mostly senior secured) for issuers while hybrids rank lower, often just above equity. The seniority of the capital instrument determines the priority in which investors are paid out in the event of a liquidation. This means hybrids will have a much higher chance of absorbing losses or being converted to equity therefore resulting in a loss of income and/or capital.
2. Ratings – FRNs are senior secured debt so have much higher ratings – the FRN index average rating by Standard & Poor’s (S&P) is AA- vs BBB- for the rated hybrids. The following extracts from S&P’s rating methodology highlight the big risk difference. As can be seen BBB- is just above speculative grade and is susceptible to changes in the economic environment.
Figure 1: Extract from S&P Rating Methodology
Source: S&P Global Ratings. Retrieved from: https://disclosure.spglobal.com/ratings/en/regulatory/article/-/view/sourceId/504352
3. Standardisation – The FRN market has more transparency and standard terms for each issue. This contrasts with the complexity of the multiple hybrid structures and terms which require interpretation. This means more work for investors to understand the specific conditions for each hybrid issue even from the same issuer.
4. Diversification of issuers – The hybrid market in Australia is generally domestic banks. There are 56 issues from 28 issuers, all Australian companies (Sep 2022).1 In contrast, the FRN market offers more diversification through the inclusion of foreign bank and corporate issuers. In addition, issuance is more frequent and larger. The FRN index contains 230 issues from 85 issuers from 19 countries (Sep 2022).2
5. Size of market – The FRN index covers A$158 billion of outstanding issuance while the hybrid market is only A$44 billion as at the end of September 2022.3
6. Liquidity – FRNs typically have better secondary market liquidity. Hybrids have a monthly trade volume of A$693m (Sep 2022), while for FRNs trade volume is estimated to be in the range from A$1.5bn to A$3.5bn.4
7. Portfolio diversification – FRNs have a lower correlation to equity markets than hybrids. Over the 10 years that we have data for the hybrid index, monthly correlation of hybrids with Australian shares has averaged 0.70 while, in the same period, FRNs have averaged 0.45.5 In addition, hybrids are generally purchased individually by investors which may make it difficult to get the required diversification compared to an FRN fund, which is a more common way to invest in these instruments.
8. Income reliability – The reliability of the income stream is higher with FRNs than with hybrids. One of the features of hybrids is that interest payments can be deferred and may not be paid at all due to the non-cumulative condition. Moreover, hybrids can fail to convert to equity if they do not meet specific conditions so maturity dates can be uncertain. In contrast, as long as the issuer is solvent, FRNs must pay income on the agreed dates and repay capital at the fixed maturity date.
9. Institutional access – FRNs are not offered directly to retail investors due to the minimum ticket size. Investing in FRNs, through a fund, therefore gives retail investors the ability to benefit from the relationships that the fund manager has with the broker dealers. This also allows investors best access to favoured names as cornerstone investors.
10. Capital stability – FRNs have historically been more resilient to market weakness and suffered smaller capital drawdowns than hybrids. With the current macro outlook being challenging, this feature of FRNs makes them more attractive than hybrids. The current yield differential 6.21% for hybrids vs 4.83% for FRNs6 (Sep 2022) is not large compared to history and may not compensate for the risk differential between hybrids and FRNs.
The charts below help illustrate some of the differences between hybrids and FRNs using their historical performance for the period for which we have reliable data - 2012 to current.
Figure 2: FRNs Have Much Lower Risk Than Hybrids
Risk vs Return by Asset Class
Source: SSGA, Bloomberg Finance L.P., as of 30 September 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable. Aus FRNs = Bloomberg AusBond Credit FRN 0+ Index; Aus Hybrids = Solactive Australian Hybrid Securities Index; Aus Equities = MSCI Australia Index; Aus Cash = JP Morgan Cash 3M Index; Aus Govt = ICE BofA Australia Government Index; Aus Corp = ICE BofA Australia Corporate Index.
Figure 3: FRNs Have a Higher Risk-Reward Ratio Than Hybrids
Return/Risk (2012 – 2022)
Source: SSGA, Bloomberg Finance L.P., as of 30 September 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Aus FRNs = Bloomberg AusBond Credit FRN 0+ Index; Aus Hybrids = Solactive Australian Hybrid Securities Index; Aus Equities = MSCI Australia Index; Aus Cash = JP Morgan Cash 3M Index; Aus Govt = ICE BofA Australia Government Index; Aus Corp = ICE BofA Australia Corporate Index.
Figure 4: FRNs Have a Lower Correlation with Equities than Hybrids
Correlation with Equities (2012 – 2022)
Source: SSGA, Bloomberg Finance L.P., as of 30 September 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Aus FRNs = Bloomberg AusBond Credit FRN 0+ Index; Aus Hybrids = Solactive Australian Hybrid Securities Index; Aus Equities = MSCI Australia Index; Aus Cash = JP Morgan Cash 3M Index; Aus Govt = ICE BofA Australia Government Index; Aus Corp = ICE BofA Australia Corporate Index.
Figure 5: FRNs Have Much Smaller and Shorter-lived Drawdowns than Hybrids
Drawdowns – Hybrids & FRNs (2012 – 2022)
Source: SSGA, Bloomberg Finance L.P., as of 30 September 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Aus FRNs = Bloomberg AusBond Credit FRN 0+ Index; Aus Hybrids = Solactive Australian Hybrid Securities Index.
Figure 6: The Drawdowns in Hybrids also Coincide with Equity Drawdowns Which Impacts Portfolio Diversification
Drawdowns – Hybrids, FRNs, Equities (2012 – 2022)
Source: SSGA, Bloomberg Finance L.P., as of 30 September 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Aus FRNs = Bloomberg AusBond Credit FRN 0+ Index; Aus Hybrids = Solactive Australian Hybrid Securities Index; Aus Equities = MSCI Australia Index.