Neuberger’s Marks: Getting the right blend in hybrid bonds

Corporate hybrid bonds are increasingly capturing the attention of yield-starved investors. These securities, which combine features of both equity and bonds, offer a diversifying asset to investors’ portfolios with a healthy average yield of 2.7-2.8 per cent.

The market has grown rapidly since 2012, after the asset class fell largely out of favour following the financial crisis. While the sector had a market capitalisation of around $20bn going into 2013, $30bn was issued in each of the following three years.

Dormant dangers

However, the asset class comes with risks; hybrid bonds sit lower down the capital structure of companies, so are at more risk in a default scenario and the callable structure has no way of guaranteeing the realized tenor.

However, the universe mainly consists of high-quality investment grade companies with strong balance sheets and a long track-record of paying equity dividends (which legally enforces coupon payments on the hybrids).

Furthermore, a non-call event is unlikely in the current market environment as the economics remain deeply in favour of calling at the first call date, while a loss of equity content from S&P, as well as reputational consideration further ensures these instruments remain short-dated in nature. With this in mind, investors require specific skills and tools to successfully navigate this blossoming opportunity and, crucially, outperform the benchmark and deliver strong total returns.

Selectivity is a virtue

Critically important is a fundamental research focused credit and valuation approach, to ensure each bond will be bought at a discount to conservative fundamental value. Given most corporate hybrid borrowers are investment grade rated, those investors with access to their own in-house investment grade teams can gain a crucial advantage and can continuously evaluate the universe. Although the limited size of the market means that patience is a crucial to be able to quickly act aggressively when opportunities present themselves.

For example, we believe that the market is too negative on the impact of Brexit on the largest utility providers. Even if we don’t have a deal on Brexit, everyone in the UK will still need those services and those companies will continue to be the ones that provide them so they are currently very cheap.

Getting ahead of the curve

With new issuance, the important thing is to manage a strong relationship with issuers and with brokers because demand significantly outstrips supply. Getting orders in early is vital to ensuring a good allocation, while consulting with issuers and brokers can enhance an investor’s reputation and result in larger allocations.

Tapping the trend

Through careful security selection, accessing new issuance and running a higher beta than the index, investors should be able to add roughly 100bps per year to the 2.7 per cent average yield for the asset class. In calmer periods, new issuance is the key to outperformance, while if things become more volatile, security selection becomes more important.

While corporate hybrid bonds are still re-emerging as an asset class, their risks are often overblown with call and coupon risk so far not manifesting in the sector. The real challenge is outperforming a sector where only 150 securities are in circulation. By taking a flexible, selective and nuanced approach, investors can outperform and, crucially, source the yield that is so hard to find in other, more risky areas of the market.

Julian Marks is credit portfolio manager at Neuberger Berman