The marked increase in fixed income investments has highlighted the demand for yield, but those rushing specifically to hybrid securities are failing to see the risks.
The problem has stemmed from a lack of material available to retail investors to make an informed assessment, Bentham Asset Management managing director Richard Quin told InvestorDaily.
"It's very hard for a retail investor to get context," he said, adding that there are no available ratings by credit agencies on the instruments.
Bentham held a reasonably negative view on domestic hybrids and highlighted that domestic pricing was very poor, Quin said.
"The credit risk premium has not been as high and that's actually a big issue," he said.
"Just because the pricing is better than before doesn't mean they're getting good value. Credit spreads globally are a lot wider than they have been historically."
While the discussion around hybrids had re-emerged, it has not evolved to communicate to both advisers and investors how poorly they can trade in a bad environment, Quin said.
Hybrids are less likely to recover if a company defaults on its payments due to its position in the capital structure, which has been witnessed in previous years.
Investors have also disregarded that in a credit portfolio much more diversity is needed than in an equity portfolio, Quin said.
"Subordination seems like a free lunch but when you least expect it, it bites you. It means you'll receive less in default and it will trade a lot more like equities in a bad market," he said.
"They have very high gamma, or they are a negative convexity instrument, so when you see equities markets first sell off they probably don't move, but when you start to get them selling off even further, hybrids can fall off a cliff.
"That is one of the things a lot of people don't fully appreciate."
Another issue investors overlooked was the correlation risk as they didn't realise they somewhat doubled their equity exposure when they held equities and then added a hybrid from the same company, Quin said.
"If you own a bank stock and then buy a bank hybrid, you're doubling up your risk and it doesn't give you a lot of diversity in the portfolio."
Hybrids should also be distinguished between bank and insurance hybrids and corporate hybrids as they behave differently, Quin said.
In addition, there was an emerging issue with structural development when poorly structured hybrids continued to pay dividends to the equity holder even if it was in default to the hybrid owner.
"There are a lot of risks. These structures can be quite challenging," he said.
A lot of advisers weren't using hybrids as they remain cautious and instead invested in deposits, Quin said.
"What they need to get across [to clients] is that hybrids are not equities and they are not debt so it's not really a debt instrument like many perceive it to be.
"I can understand why people hold direct equities but holding direct hybrids is not as smart as it sounds, which is what we'd call this credit-style investment," he said.
