When an apparently sleepy, decade-old market suddenly explodes into life, it is natural to ask what that means for investors.
That is what happened to non-financial corporate hybrid securities during 2013-14 when, after years edging its way towards $20bn, the market exploded by well over 300 per cent.
A hybrid security is debt capital that has characteristics of both debt and equity. They are subordinate to senior debt but senior to equity. They pay coupons, but the issuer can stop paying them without defaulting, and they will usually be either extremely long-dated or perpetual. Rating agencies can regard a proportion of hybrid capital as equity, depending on how they are structured – and it was a series of clarifications on this from the big agencies that has given the market its great impetus since 2013.
Hybrids deliver extra yield relative to investment-grade senior bonds, even though nearly all of the issuers and more than 70 per cent of the securities are investment-grade. There are many stable utilities and telecoms among their number, and two-thirds of issuance comes from companies based in the UK, Germany and France.
While the agencies rate hybrids two or three notches lower than the same issuer’s senior debt, that leaves us with an average rating of BBB/BBB-. On an option-adjusted basis, hybrids have yielded between 200 and 600 basis points more than the average investment-grade bond. Today the difference is around 300 basis points. To get the same spread in senior debt investors would have to go to high-yield issuers rated BB.
You might assume you are getting paid for the risk that issuers might defer their coupons or leave their hybrids outstanding at their first call date. But we think these outcomes are highly unlikely.
We cannot find any example of missed coupons. Investors might consider the case of Dutch telecom KPN, which maintained its hybrid coupon payments even after it suspended its dividends in 2013: a clear signal that issuers will protect their reputation with bond markets even if they run into some trouble.
Hybrids do tend to trade to their first-call date, usually between five and 10 years after issuance, so any hint of an extension can affect valuation. Again, reputational damage acts as a big disincentive to extend, but hybrids are also structured to mitigate extension risk still further. An uncalled hybrid’s coupon “steps up” to a higher level, and if it remains outstanding it will be reset several times again. To compound this for the issuer, most hybrids lose their equity credit from S&P on their first call date – effectively making them ever more expensive senior debt.
For these reasons we believe the vast majority of hybrids will pass their lives as no-frills, high-yielding, five or 10-year subordinated debt.
Hybrids are good value not because they represent a lot of extra risk but because they slip through a gap in traditional fixed income coverage. Investment-grade portfolio managers will know the issuers, but may be uncomfortable with subordinated capital. High-yield managers, on the other hand, are unlikely to know these predominantly investment-grade issuers.
Even after accounting for more than 100 basis points as a premium for subordination, coupon deferral and extension or early-redemption risks, the market still offers a further 100 basis points or more of residual spread, on average. These securities offer a genuinely high yield from a growing number of overwhelmingly investment grade issuers whose management teams are well aligned with investors.
Julian Marks is a portfolio manager in investment grade credit at Neuberger Berman