Understanding Bonds & Hybrid Securities

The Basics of Debt and Hybrid Securities, with Tom McBride

What is a Debt Security?

A debt security is a financial instrument that is issued to investors in exchange for their money. Also known as a Bond. A debt security is a liability on the balance sheet for the issuing company, and they have a contractual obligation to pay periodic interest and repay the balance borrowed at maturity.

What is a Hybrid Security?

A hybrid security is also a financial instrument. Similar to a debt security, they are issued to investors in exchange for their money. A hybrid security has debt and equity-like characteristics. The benefit to an issuer of issuing an equity like instrument relates to a portion of the funding sitting on the equity side of their balance sheet, reducing the impact on any debt covenants.

Who Issues Bonds?

Many of the well-established NZ publicly listed companies issue debt and hybrid securities.

There have been a number of recently issued Bonds and we have summarised a few below with their yield to maturities. These are not recommendations, merely a sample of the sort of offers that are on issue.

  • Transpower NZ (TRP080), unsecured & unsubordinated debt securities, coupon of 1.520% p.a, YTM of 4.97% p.a, credit rating of AA-, maturing in April 2026.
  • Bank of New Zealand (BNZ160), unsecured & unsubordinated debt securities, coupon of 4.985% p.a, YTM of 5.15% p.a. credit rating of AA-, maturing in June 2027.
  • Auckland International Airport (AIA250), unsecured & unsubordinated debt securities, coupon of 5.73% p.a. YTM of 5.12% p.a. credit rating of A-, maturing in May 2028.
  • Kiwi Property Group Ltd (KPG060), secured and unsubordinated debt securities, coupon of 6.24% p.a. YTM of 6% p.a., credit rating of BBB+, maturing in September 2029.

Figures as of the 7th of February 2024.

This is a conservative approach to managing interest rate risk. An evenly laddered maturity profile limits the impact of interest rate volatility on the portfolio, minimises income volatility and results in a superior long-term return for debt and hybrid security portfolios.

Why do Investors Purchase Debt & Hybrid Securities?

Debt and hybrid securities are utilized in portfolio construction for the purpose of lowering return volatility, providing a stable consistent income return, and safeguarding value.

We often recommend clients include debt and hybrid securities in their investment portfolios to reduce portfolio risk and better align the risk level of the portfolio with their personal approach to risk. This can be viewed as an investor’s willingness and ability to bear risk.

If you would like more information on debt and/or hybrid securities, please contact one of our advisers.

Terms Sheet and Product Disclosure Statement

These documents include the terms sheet and the product disclosure statement. It is important for investors to read these documents to understand the terms of the offer and the nature of the securities being issued before committing to an application.

The terms sheet is a brief summary communicating the key terms of the security being issued. For example, it includes information on the timeline, amount being raised, purpose for the funds being raised, interest rate and maturity date, just to name a few.

The product disclosure document (PDS) is a legal document that is required to be published by issuers bringing a new security to the market. The PDS must be communicated to investors prior to investing in a new issue of securities, with one exception. Serial issuers of debt & hybrid securities can rely on a PDS they have already published for existing securities that are trading on the secondary market, provided the new issue is on the same terms as the securities that have already been issued. In this instance, the issuer will only provide a terms sheet for the new issue, noting in the terms sheet their reliance on a previously published PDS. Product Disclosure Statements are freely available on the internet via the NZ Companies Office Disclose Register.

Your adviser will send you the terms sheet for new issues of debt or hybrid securities, along with the PDS for new issues whereby the issuer is not relying on a PDS for previously issued securities.

The following terms may be familiar to some of you, or completely foreign. These terms are most commonly found in the legal documents published by companies intending to issue debt or hybrid securities to retail investors.

Key Terms Explained

The following terms may be familiar to some of you, or completely foreign. These terms are most commonly found in the legal documents published by companies intending to issue debt or hybrid securities to retail investors.

plus small outer thick gold-iconSecurity
A negotiable financial instrument that holds some type of monetary value.
plus small outer thick gold-iconNew Issue

A new issue is a newly created security/financial instrument that is offered to investors for the first time.

plus small outer thick gold-iconSecondary Market

The secondary market refers to a marketplace for buying and selling securities that have completed the new issue stage. The secondary market enables investors to acquire investments and divest investments before maturity.

plus small outer thick gold-iconPar Value

Par Value refers to the value per security at the new issue stage. This is often $1 per security.

plus small outer thick gold-iconCoupon Rate

The coupon rate refers to the return investors will receive from distributions paid by a security that an investor acquires as a new issue and holds to maturity. Coupons are paid per security, not on the value of the holding. This is relevant where an investor acquires a debt or hybrid security on the secondary market, where they routinely trade above or below their par value. Where an investor acquires a debt or hybrid security on the secondary market above its par value, their annual return to maturity will be less than the coupon rate, and vice versa.

The coupon rate for a debt or hybrid security is set prior to the security being issued to the market as a new issue. The product disclosure statement and terms sheet for the new issue will outline the process for setting the coupon rate. The coupon rate is set with reference to market-based interest rates called Swap Rates. There are swap rates for many different time periods; if an issuer were to issue a 5-year bond, the interest rate would be set by reference to the 5-year swap rate. This is the rate that an investor or borrower would be prepared to lend or borrow at a fixed rate, without factoring credit risk. Basically, swapping their floating rate investment/debt for a fixed rate.

The coupon rate will be set as the swap rate that is relevant to the maturity date of the new issue, plus a credit margin that compensates the investor for the credit risk associated with the company and the characteristics of the security to be issued. For example, a bond being issued by Company A with a maturity date in 5 years’ time will have its coupon set as the 5-year swap rate, plus a credit margin.

plus small outer thick gold-iconYield to Maturity

The Yield to Maturity on a debt or hybrid security reflects the annual return an investor will enjoy by holding the security to maturity. The Yield to Maturity will equal the coupon rate when a debt or hybrid security is purchased at the new issue stage at par value. However, the yield to maturity will likely differ from the coupon rate, where an investor purchases the debt or hybrid security on the secondary market. For example, if an investor purchases a bond with a coupon of 5% p.a. at a yield to maturity of 6% p.a, the investor is purchasing the bond at a discount to its par value. At maturity, the investor will receive the par value of the bond, often $1, and the final distribution. A portion of the investor’s return, reflected in the Yield to Maturity, will be capital appreciation/depreciation, the difference between the investor paid per security and the par value.

plus small outer thick gold-iconMaturity Date

The lion’s share of publicly listed debt and hybrid securities in NZ have fixed maturity dates, commonly between 5 and 7 years from the issue date. However, some debt and hybrid securities will have a fixed maturity date that may be 20 or 30 years in the future, but they often provide the issuer the option to repay that security early, in say 5 years from the issue date. This feature is called a redeemable or callable option.

Where a debt or hybrid security has a callable or redeemable feature, and the issuer chooses not to repay the funds borrowed at the call/redemption date, the security will often reset its interest rate to a new market-based rate. This new interest rate may be fixed for a number of years, or until the next distribution date. Often, issuers will retain the option to repay investor funds at each distribution date, this may be semi-annual or quarterly.

At maturity, investors are repaid the par value of their debt or hybrid securities, along with their final coupon.

plus small outer thick gold-iconDuration

Duration is a measure of the sensitivity of the capital value of a portfolio of debt and/or hybrid securities to changes in interest rates. Duration is a numerical score and indicates the degree to which the capital value will change in response to a change in interest rates. A duration score of 3 indicates that for every 1% change in interest rates the capital value of the debt and/or hybrid securities portfolio will change by 3%.

plus small outer thick gold-iconNew Issue Types

Debt securities can be issued as very simple fixed rate bonds, or they can be a creative masterpiece, put together by financial engineers. Most debt securities issued in NZ will sit somewhere on the continuum between a simple (vanilla) bond and a complex hybrid security.

1. Unsecured: These debt securities are not secured over land & permanent buildings (tangible assets). Many industries and sectors in NZ inherently do not have significant tangible assets, yet they have a high degree of credit worthiness. This may be an IT company, or a healthcare company, with great credit metrics, reliable cash flows and a well-established business. The fact that the bond is unsecured can reflect the type of industry issuing the bond, rather than the issuer’s reluctance to provide security. For example, NZ property companies and trusts often issue secured bonds, on the basis that their asset base consists of tangible buildings and land.

2. Secured: These debt securities are secured via first or second mortgage over tangible assets of the issuer. This provides investors with some security, should the issuing company go out of business and suffer a liquidation event.

All things being held equal, the coupon rate on secured debt may be lower than unsecured debt securities on the basis of the additional security, which increases investor confidence in being repaid on time and in full.

3. Unsubordinated & Subordinated: Unsubordinated debt securities rank ahead of subordinated debt securities in the event of the business being liquidated. All things being held equal, you would expect to receive a higher coupon rate on a subordinated security for the additional risk, relative to a comparable unsubordinated security.

4. Convertible: These debt securities often have a fixed coupon rate for a period of time (5 years or more) with an option to convert the debt securities to common equity, based on an agreed ratio, at the discretion of the issuer. Similarly, to subordinated debt securities, all things being held equal, convertible debt securities often pay higher coupon rates than debt securities that do not have a convertible option (at the issuer’s discretion).

5. Callable/Redeemable: This is an option which is often to the benefit of the issuer. A callable security has a call date attached to it, which gives the issuer or the holder, but most commonly the issuer, the right to repay the bonds at a particular point in time prior to the maturity date. Securities with call dates often have a higher coupon rate to compensate the security holders for the risk associated with being repaid prior to the maturity date. Whichever party has control over exercising the call option has no obligation to repay the securities at the call date; its merely a right to exercise the option. A bond with a call option exercisable by the issuer can be to the benefit of the issuer in a declining interest rate environment. However, in a rising interest rate environment, the issuer would be less likely to call the bond, on the basis that refinancing would be more expensive.

Frequently Asked Questions

plus small outer thick gold-iconWhat do Credit Ratings Mean?

Credit ratings are issued by specialist credit rating agencies, they commonly include Standard & Poor’s, Moody’s, and Fitch. Standard & Poor’s are one of the most frequently cited credit rating agencies in NZ for new issues of debt & equity securities. On this basis, we have focused this article on the Standard & Poor’s credit rating process.

Issuers, including corporations, financial institutions, national governments, states, cities, and municipalities, use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt or equity issues.

In forming their opinion on credit risk, credit rating agencies use analysts and mathematical models. The process begins with an issuer requesting a credit rating from one of the three credit rating agencies listed above. They pass through an initial evaluation; analysts meet with management and evaluate the company. A rating committee will review the analysts’ work and vote on a credit rating. The credit rating will be communicated to the issuer, released publicly, and kept under surveillance by Standard & Poor’s.

The Standard & Poor’s credit ratings have been broadly summarised below,

The term “investment-grade” historically referred to bonds and other debt-like securities that bank regulators and market participants viewed as suitable investments for financial institutions. Now the term is broadly used to describe issuers and issues with relatively high levels of creditworthiness and credit quality.

At Hamilton Hindin Greene, we prefer to limit our recommendations to investment grade credit rated securities. Fixed interest securities represent the defensive component of your portfolio, so they will ideally have a high credit rating to reflect a low level of credit risk.

plus small outer thick gold-iconHow Do Companies Issue Debt & Hybrid Securities?

The process for raising funds via a new issue of debt or hybrid securities on the New Zealand Debt Market (NZDX) involves an issuer working with an investment bank or NZX market participant. The investment bank or NZX market participant is responsible for organising the issue of securities, along with distributing the securities amongst NZX participants and their own clients. This organization will be referred to as the lead manager. Some new issues will have multiple organisations assisting the issuer with distributing the securities, these organisations are collectively called Joint Lead Managers.

When an issuer is intending on issuing a new security, they will often release an announcement to the market that they are considering issuing a new security. Concurrently, or soon afterwards, the lead/joint lead manager will reach out to the NZX market participants they have a relationship with to communicate brief details on the potential new issue of securities. These details often include the name of the issuer, nature of the securities that may be issued, amount on offer, and the terms of the issue. This is often accompanied by an invitation to an investment roadshow.

The investment roadshow is either an in-person session organised by the lead manager/joint lead managers with the CEO and CFO of the issuer at the lead manager’s offices, or a conference call with the CEO and CFO. Our advisers routinely attend roadshows to better understand the issuing company’s business and to express our interest or lack of interest in the securities to be issued.

Following the roadshow, an indicative terms sheet, and if necessary, a PDS will be published and communicated to the NZX Participant firms by the lead/joint lead managers. The lead/joint lead managers will then make contact with NZX Participant firms to gauge their interest, on behalf of their clients, in the securities to be issued. This is called an indicative bid, which is lodged with the lead or one of the joint lead managers. The following day, the lead or one of the joint lead managers will request a firm bid in dollar terms from the NZX Participants. This will be the maximum amount of the new issue the NZX participant will receive.

If the lead/joint lead managers receive firm bids from NZX Participants for an amount that exceeds the size of the issue, they reserve the right to scale applications. For example, if an NZX participant makes a firm bid for $10m of a new issue of bonds from Infratil Ltd, the overall size of the issue is $100m, and the lead/joint lead managers receive total firm bids for $200m, the lead/joint lead managers may decide to scale the number of securities the NZX Participant receives by 50% to $5m of securities.

Once the NZX Participants have been informed of their allocation of new securities by the lead/joint lead managers, they will then communicate the offer to their clients, along with the appropriate legal documents and provide recommendations where appropriate.

An NZX Participant has a legal obligation to the lead/joint lead manager to satisfy their allocation of securities by the closing date of the offer.

This is why the time frame for confirming whether you wish to take up a new issue of securities is often very short. The securities will be allocated to clients by the issuer on the ‘issue date/allotment date’, recorded in the terms sheet and PDS.

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