They combine some of the features of shares and bonds and can be complex. Like a bond, they can provide regular income but, like a share, they are traded on the stock exchange and their price can fall sharply if the company that issues them encounters trouble.

Hybrids typically pay a specified rate of return – which can be fixed or floating – until they mature at a predetermined date. Unlike a bond though, there is no guarantee about the amount and timing of interest payments, which remain at the discretion of the bank.

Each hybrid is different so you need to read the fine print and make sure you really understand them.

Risks of investing in bank hybrids

Hybrids are “loss-absorbing” which means investors can lose their money if the bank gets into financial trouble. This can happen through the hybrids being converted into shares in the bank or written-off. This “loss absorption” is designed to protect bank depositors, although it is worth noting this has never actually been done in Australia.

In the event of conversion, it is investors, not the bank, that are at risk of suffering a loss, which is how it protects depositors.

Each hybrid has a different amount of risk, depending on its individual features.

The most common risks include.

  • Liquidity – in a crisis buyers for the hybrid may dry up, and if you need to sell quickly, you are likely to get a much lower price.
  • Interest payment deferral – some hybrids allow the issuer to withhold interest payments if they get into financial difficulty.
  • Last to be paid – you rank below other creditors to the bank, such as depositors, so if it fails there may not be any money left to pay you after other creditors have been paid.
  • Can convert to shares – your hybrids can be involuntarily converted into shares at the worst possible time – when the bank is in financial trouble.
  • Long maturity dates – hybrids investment terms can be decades long, meaning the chance of default at some stage is higher.
  • No Government guarantee – hybrids are not deposits so they are not covered by the Federal Government’s deposit guarantee, unlike a term deposit.
  • 'Knock out' options – some hybrids can be written off completely if the issuer gets into financial difficulty, leaving you with nothing.

Benefits of investing in bank hybrids

Despite the risks, bank hybrid securities are popular because they carry some benefits.

  • Risk – bank hybrids generally have more price stability than shares
  • Income - Pay regular income at a pre-determined rate (unless the bank gets into trouble)
  • Liquidity - Easy to buy or sell on the Australian Securities Exchange
  • Strong return - Higher interest rate than term deposits (reflecting higher risk)
  • Diversification – hybrids can offer diversification which tends to reduce overall portfolio risk

Alternatives to bank hybrids

Bank hybrids are often attractive to investors who want regular income with less volatility than the share market.

Another type of security that can offer this is Residential Mortgage-Backed Securities (RMBS). These are comprised of loans secured against residential property.

As they are pools of residential mortgages, they are not exposed to any single financial institution. This is important from a credit perspective as it is the broader Australian economy that dictates the performance of RMBS, and not the value of any financial institution.

Direct investment in RMBS is generally limited to large financial institutions, but ordinary investors can get access through an RMBS managed fund.

One such fund is Firstmac High Livez, which owns a portfolio of RMBS from some of Australia’s best-known institutions, plus some bank deposits.

High Livez aims to pay investors regular monthly income.

For more information about High Livez, see here.

What to do before investing in bank hybrid securities

Bank hybrids are complex securities that are all unique. Before investing you should:

  • Read the prospectus
  • Get advice from a professional adviser