The fixed income asset class has a fairly widespread reputation for being conservative and less rewarding than other asset classes. Fixed income instruments usually rank above equity in the capital structure of a corporation, and as such, have a higher claim on a company’s assets in the event of bankruptcy.
As such, fixed income assets usually have lower yields since there is slightly less risk. However, many different types of fixed income instruments have been created and issued which can appeal to traditional equity investors who crave higher returns but slightly less risk.This week, we take a closer look at hybrids — fixed income instruments with features of both debt and equity. These instruments are most commonly issued by large financial institutions across the globe, and they form part of their tier 1 or tier 2 capital base. The capital base of a financial institution, from an accounting standpoint, is classified as equity. However, this “equity” ranks above common or even preferred equity.Let’s take a look at the features that hybrids share with debt and equity. For example, they pay a fixed or floating coupon at pre-established intervals. However, the issuer usually maintains the right to suspend this payment. Similarly, hybrids can have a maturity date, but this date is usually very far into the future, for example, 30 or 40 years. Maturity dates far out into the future and the ability to suspend interest or principal payments are some of the common “equity like” features of hybrids. Hybrids also have another very important feature; they usually contain an embedded conversion option, which allows the issuer to convert the principal of your investment into common equity in very specific circumstances. These circumstances usually describe severe financial difficulty which threatens their ability to meet their minimum capital requirements. To compensate investors for these risks, the issuing institutions usually pay a relatively attractive coupon rate.These types of instruments also display more price volatility than other plain vanilla bonds, and can provide more opportunity for capital gain. Capital gain is an important source of return for the active equity investor. Bonds can also provide generous returns through price appreciation. The price of a bond can rise and fall, just like a stock. However, the issuer has effectively guaranteed you repayment at 100 cents on the dollar. However, during the life of the fixed income instrument, many factors can cause the price to rise or fall. Much like equities, these notes are affected by the company’s financial or strategic market position, general news, and changes in the macro or micro economic landscape. It is also important to note that bonds are not only for low interest rate environments. Fixed income instruments can be structured to take advantage of rising interest rate volatility and higher interest rates. In sum, the fixed income asset class is versatile and can still provide very attractive returns for relatively lower levels of risk than equities.Another important premise here is that investors do not have to compromise the creditworthiness of their investments in order to attain higher returns. There are many different types of structures that can be tailored to the different risk appetites investors. These types of instruments allow an investor to preserve the high credit quality of their investments, by taking on other risks that do not threaten the principal of their investment.Marian Ross is Assistant Vice President – Business Development with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.com.jmView the original article here
Bonds for equity investors
