Investors have snapped up stock in a new type of hybrid security that has made its appearance in the Australian investment market during the past couple of months. The appeal of these "mandatory convertibles" lies in their high yields and the strength of the groups issuing them but, like all hybrids, they are complex instruments and may hold some surprises for the unwary.

Investors looking for high yields should take some time to get to know mandatory convertibles because investment bankers say there are more on the way.

What they should pay particular attention to is whether the distributions are franked or unfranked. If the distributions are franked, investors may face delays in realising the value of their distributions.

And they should look closely at the conversion and transfer conditions. Mandatory convertibles are supposed to convert to ordinary shares in the issuing company at a future date but there are provisions for getting cash back instead of shares. These conditions may vary.

Three issues of mandatory convertibles have come to the market this year. Macquarie Convertible Preference Securities pay a fixed rate, set at 3.5 per cent over the bill rate at the date of issue. That rate has been set at 11.095 per cent.

Suncorp Convertible Preference Shares are floating-rate securities priced at a 3.2 per cent margin over the 90-day bank bill rate (currently 7.7 per cent) at each distribution date. Westpac Staples Preferred Securities are also floating-rate securities, priced at a margin of 2.4 per cent over the 90-day bank bill rate at each distribution date.

Hybrid structures are an outcome of changing regulatory, tax, accounting or ratings rules.

They are called hybrids because they have the characterstics of both equity and debt. One investment banker - Citigroup's head of hybrids, Fraser Todd - describes them as dynamic and flexible investment securities.

In this case, the Australian Prudential Regulation Authority established some criteria in 2006 for a class of capital instruments that could be counted as part of a financial institution's regulatory capital. Among the conditions set by the authority, these instruments have to be convertible to ordinary shares.

Macquarie CPS convert to Macquarie Group ordinary shares in June 2013, the Suncorp conversion date is also in June 2013 and Westpac's is in September 2013. Many private investors have put their money into these hybrids to earn a yield and want their cash back later. They are not interested in holding stock in the company issuing the hybrids.

All mandatory convertible issues make a provision for what is called a transfer mechanism to give investors their cash back rather than shares at the conversion date. For example, the product disclosure statement for Westpac's Stapled Preferred Securities says: "On the mandatory conversion date it is expected that the Westpac SPS will be either converted into ordinary shares or transferred to a nominated party for $100 cash per Westpac SPS."

What this means is that Westpac has put a mechanism in place to give investors cash instead of shares when the conversion deadline arrives. But will that happen? No one knows.

The head of hybrid capital at Deutsche Bank, Rupert Daly, says: "Investors won't know until year five. The bank will make a decision as the conversion date approaches."

Deutsche was the adviser to Westpac on the structuring of its Stapled Preferred Securities. Daly says: "In all expectation, a transfer notice will be issued. The issuer wants to make sure the investors are appropriately managed. The issuer will want to ensure that it can keep doing these kinds of instruments."

Another issue for investors is the way distributions are paid.

Westpac and Suncorp are paying franked distributions; Macquarie is not.

When investors think of shares the mention of franked dividends makes their eyes light up. It means they are getting tax-effective income.

It works a bit differently with hybrids. In the case of Westpac SPS, the distribution rate is 2.4 per cent over the bill rate (currently 7.7 per cent), so investors get a yield of 10.1 per cent.

Because the distribution is franked, only 70 per cent of the distribution is paid in cash and the balance is paid in the form of a franking credit. That franking credit provides the investor with a tax deduction and a refund on any excess credit, so the 10.1 per cent yield is achieved. But investors may have to wait up to a year to claim their franking credits.

An unfranked distribution, such as the one being paid on the Macquarie Convertible Preference Securities, provides cash in the hand for the full amount of the distribution. Because there is no delay in realising full value, it is a better deal.

The head of hybrids at National Australia Bank's investment banking division nabCapital, Nicola Monteiro, says: "Investors need to understand that a franked distribution means they will receive 70 per cent in cash and then wait to claim their franking credit. Investors have come to think of franking as a good thing but not in this case."

Citigroup's Todd says: "Technically, if you look at the time value of money, a gross distribution has a higher value. But different investors have different needs."

Deutsche's Daly says: "The majority of hybrid deals over the years have had franked distributions. The credits are fully refundable. We have not seen any adverse reaction."

MANDATORY CONVERTIBLES                                                          
Issuer         Westpac             Macquarie Group              Suncorp
Security               Stapled Preferred Sec       Convertible Preference Sec   Convertible Preference Sec
ASX code               WBCPA               MGCPA                                SUNPB
Distributions   Fully franked, floating rate,  Unfrank, fixed, 3.5% above       Fully franked, floating rate,
               2.4% above bank bill rate           bank bill rate at - 11.095   3.2% above bank bill rate
Conversion     September 26, 2013          June 30, 2013                        June 14, 2013