When allocating to income, investors need to focus more on where investment sits in the capital structure or face unnecessary portfolio risk, according to bond manager PIMCO.
Typically, government guaranteed debt, covered bonds and senior secured debt are higher in the capital structure than unsecured debt and subordinated debt – with hybrid securities and equities at the bottom of the scale, according to PIMCO portfolio specialist Michael Dale.
"The difference is that equity represents an ownership stake, while debt is a legal obligation to be repaid," Dale said.
"Secured debt reduces risk to the investor even further, providing a claim over assets of the corporation," he said.
In regards to hybrids, Dale said investors often get caught out on capital structure risk because there is a disparity in the characteristics of the investment option.
He said hybrids are "almost invariably subordinated to all forms of debt" and PIMCO stated that it does not believe hybrids should be considered a substitute for fixed income.
"Distributions from hybrid securities and equities are discretionary and variable. In times of stress, companies can, and often do, cut dividends," Dale said.
Hybrids often "dilute overall portfolio returns" because they act more like equities in bear markets and more like fixed income in bull markets, but do not necessarily reduce risk, he said.
"Simply put, investors today are better off lending at the top of the capital structure than owning at the bottom," Dale said.
