Retail investors are buying into hybrid investments based on the household name or familiarity of the issuer, rather than considering the different dimensions of risk in the asset class.
"Often, the complexities of hybrids are overlooked by a lot of investors who are simply looking at the name of the issuer that is putting the security to the market," Russell Investments fixed income portfolio manager Clive Smith told InvestorDaily.
"Most of the hybrid issues that have come out have been the major banks, household or quality name issuers, such as insurance companies, so a lot of retail investors are therefore quite comfortable with hybrids and the names that they've been issued under."
However, such issues were effectively floating securities and therefore investors might not fully appreciate the credit risk involved when buying into hybrids, in addition to the potential of issuers moving from being blue-chip to non-blue-chip, resulting in material impacts on returns, Smith said.
Advisers and investors needed to understand the different dimensions of risks associated with fixed-income portfolios, he said.
"Investors need to proactively manage the different dimensions of risk that there are in fixed-income markets and also need to keep in mind the ultimate credit risk that is involved," he said.
"They must consider any additional risk and contingent liabilities."
Another risk retail investors are overlooking is interest-rate-sensitive investments, which are important diversifiers, particularly for credit-oriented portfolios.
"There are added complexities that they need to consider when looking at hybrids; they are not just simple securities and it's not just a senior debt issue," Smith said.
"The key thing for investors when putting together portfolios is to make sure there is adequate diversification to cover those eventualities where market events may arise, which you cannot respond to."
On the other hand, the types of hybrids currently available in the market were now more equity-like and very concentrated by industry, according to Bentham Asset Management managing director Richard Quin.
"As a result, I wouldn't classify them as an investment asset class as such," Quin said.
"Due to the concentration of the investable hybrid market, it would be inappropriate for individual investors to hold large portfolio allocations to these assets, however, a few small hybrid holdings may be appropriate if they occurred with a corresponding decrease in an investor's equity holding."
While deeply subordinated debt seemed like a "free lunch" as investors got paid more for the same probability of default, it might actually lead to much more volatile returns and less liquidity in difficult market conditions, he said.
"However, there are a number of these issues available in the market, given their attractiveness to issuers as a cheap form of equity," he said.
"It is possible to get equivalent or better yields without being deeply subordinated in the capital structure as hybrid investors tend to be, albeit it is difficult for a retail investor to achieve that without using a managed portfolio."
