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As 2013 draws to a close, we examine the recent emerging trend of growth in the corporate hybrid part of the bond markets in Europe. This year has seen hybrid issuance of around €22bn to date (source: SocGen), which is the highest on record, and has doubled the size of the European corporate hybrid market. Is the growth of these instruments something that credit investors should be worried about?
Primer
Corporate hybrids are bonds that combine debt and equity-like features. They pay a coupon but often have no definite maturity date, and have other equity-like features, such as the ability to defer or cancel coupons without triggering a default. They are subordinated debt instruments, which rank below senior bondholders (who are paid first in case of a default); however, all hybrid coupons, including missed payments, must be paid in full before dividends can be paid to equity holders. For senior bondholders they can be supportive by creating a loss absorbing cushion ahead of the senior bonds.
Corporate hybrids are bonds that combine debt and equity-like features. They pay a coupon but often have no definite maturity date, and have other equity-like features, such as the ability to defer or cancel coupons without triggering a default. They are subordinated debt instruments, which rank below senior bondholders (who are paid first in case of a default); however, all hybrid coupons, including missed payments, must be paid in full before dividends can be paid to equity holders. For senior bondholders they can be supportive by creating a loss absorbing cushion ahead of the senior bonds.
This year, they have been increasingly in favour with non-financial corporate treasurers who are keen to raise capital without compromising the investment grade senior debt ratings of the company, or diluting existing shareholders by issuing more equity*. The current low interest rate environment means that the cost of issuing corporate hybrids for companies is not prohibitive (in absolute terms), while investor demand and risk tolerance is high given the attractive yields compared to typical corporate bonds. However, these securities expose investors to additional risks including maturity extension (the issuer has the option to redeem the bond at the call date but may choose not to in certain circumstances), and coupon deferral risk (should the issuer get into severe financial difficulty). In practice, the reputational damage from deferring coupons can outweigh the relatively small cash savings from not paying interest on the debt.
Our view
In the past, corporate hybrids have been issued by large companies with utility-like cash flows, and often to finance merger and acquisition (M&A) activity. However, we are now seeing a wider range of issuers for these debt instruments including Telefonica, America Movil and Volkswagen. The levels of issuance that we see, while sometimes associated with markets near a peak, have been exacerbated by the prevailing low interest rate environment. We do not expect this pick-up to necessarily be a good indicator that we are at the ‘top’ of the market, until we see the quality of the issuers fall further, and linked to this, the level of M&A activity pick up.
In the past, corporate hybrids have been issued by large companies with utility-like cash flows, and often to finance merger and acquisition (M&A) activity. However, we are now seeing a wider range of issuers for these debt instruments including Telefonica, America Movil and Volkswagen. The levels of issuance that we see, while sometimes associated with markets near a peak, have been exacerbated by the prevailing low interest rate environment. We do not expect this pick-up to necessarily be a good indicator that we are at the ‘top’ of the market, until we see the quality of the issuers fall further, and linked to this, the level of M&A activity pick up.
On this theme, in the high yield market there has also been a resurgence of PIK (payment in kind) bonds, which have a longer history than corporate hybrids (particularly in the US), and tend to be issued during periods of higher risk tolerance and optimism. These are subordinated bonds issued by high yield companies that do not pay an annual coupon. Instead, interest can be deferred and accrued into more bonds, with no cash payable until a future date.
Currently, corporate hybrid bonds represent around 2% of the investment grade benchmarks such as the iBoxx euro corporates index and iBoxx sterling non-gilt index. Within our investment grade portfolios, our preference this year has been to focus on the hybrid bonds of higher quality issuers with stable investment grade senior debt ratings (eg, Scottish & Southern, EDF), where we have strong conviction on the issuer. High yield portfolios tend to be a more natural home for the lower-rated hybrid bonds given their higher price volatility, and the growing market is providing good opportunities to cherry-pick by issuer, based on our underlying credit assessment.
*Typically, the ratings agencies award a 50% equity credit to these bonds so they count towards capital
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