The scary part about the recent market turmoil is that supposedly safe stocks like the banks were among the worst performers.
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In fact they're partly to blame. All right, not as much as the Greeks. But because the big banks account for 30 per cent of the market they dragged down the All Ordinaries with them, something you can use to your advantage, which I'm coming to.
They were weakening anyway, except with dividends to die for there must be a natural floor. Westpac is down double digits from its high in April though its converting preference shares shed barely 1 per cent.
These are known as hybrids, a sort of genetically modified share. They're listed and pay a floating interest rate quarterly which, bizarre as it sounds, includes a franking tax credit but isn't franked. When they mature they convert to shares in the mother stock with some extra ones thrown in.
The franking credit is already built into the interest rate, unlike a dividend where it's an extra.
Because they also sit near the top of the capital ladder, the banks love issuing them.
Likewise, DIY super funds love snapping them up because they pay more than a term deposit – compensation for losing the government guarantee – and come with seemingly impeccable banking credentials. Most of all, their prices don't bob about like ordinary shares.
So what's not to like about them?
Well the interest rate is lower than the dividend yield on the shares. Take Westpac again. Its shares are yielding 7.5 per cent after the 30 per cent franking tax credit. Its hybrid pays only 5.5 per cent, which already counts franking.
So it's costing 2 per cent a year for the peace of mind of not having wild movements in your capital, a price many think is worth it.
Fine, just so long as you don't fall for the line that a bank hybrid is somehow safer than its shares. It isn't, despite being less volatile.
And hybrids are designed for failure. They're a shock absorber if a bank gets into trouble. It doesn't pay you back, just dumps new shares on you any moment there's a crisis. This, needless to say would be at the worst possible time.
Don't think the banks can get into strife? In the GFC they were forced into jumbo capital raisings at depressed prices in what proved to be one of the century's great give-aways for investors.
And the GFC wasn't even their fault. But "banks tend to have a major solvency crisis every 20-25 years. Our last one was in 1992…" That thought for the day is courtesy of Graham Harman from Russell Investments.
It's just as well the regulators are insisting the banks beef up their capital. The point is by making the banks stronger, their hybrids also become less susceptible to an early equity conversion at the worst possible time.
In any case, the relative attractions of bank shares and hybrids are changing.
Shares have had the advantage of rising dividends - having been slashed during the GFC, let's not forget - while interest rates were falling. But dividends are close to peaking and interest rates seem to have bottomed.
Still, thanks to the better treatment from franking as well as the long term prospect of capital gains the shares will always have a head start.
The strength of hybrids is their stability but that works both ways. It stops them rising much. Besides, there's a way around their volatility even if it is a bit rough and ready.
There's a bear share that always rises when the market falls. With the apt code of BEAR it tracks the ASX200 so when the banks drop, the bear share rises and you don't go backwards.
Better still, on market bad-hair days you could take a profit on the bear shares to stock up on the cheaper banks.
