The current economic environment, characterised by higher interest rates and increased market fluctuations, has made credit a potentially attractive asset class for diversification, income generation, and stability.
Corporate Hybrid bonds are now a significant proportion of the credit market but as an asset class, it still flies under the radar for many investors. Often confused with Contingent Convertibles (CoCos), yet far more investor friendly, corporate hybrids are generally issued by high quality, investment grade, non-financial issuers. No banks and no insurance companies.
The bonds themselves are relatively simple. They contain some equity-like features – hence the term ‘hybrid’ – crucially however, they cannot be converted to equity or written down while the issuing company is a going concern. These bonds are long dated or perpetual, which is similar to common equity, however, Corporate Hybrids are callable typically between 5-10 years from issuance. They are subordinated to senior bonds in the capital structure of companies and the coupons are deferrable at the discretion of the issuer. Importantly, there are extremely strong incentives for the bonds to be called at the first call date and for coupons to be paid.
The real attraction for investors is that yields on Corporate Hybrids are significantly higher than those on senior bonds of the same issuers. Investors are essentially offered a high-yield-type coupon from strong investment grade issuers. Due to their structural features, Corporate Hybrid bonds are typically more volatile than senior investment grade bonds. However, they tend to be less volatile than high yield, despite offering comparable yields. They are also far less volatile than equities. We are yet to see a single Corporate Hybrid default since the asset class became standardised over a decade ago.
Do corporate hybrid bonds suit a particular type of investor? What role can corporate hybrid bonds play in a portfolio? How might corporate hybrid bonds fit into e.g. a 60/40 portfolio?
We believe corporate hybrid bonds have a strong appeal across a range of investors. Essentially, investors are purchasing subordinated bonds of high quality, non-financial issuers and then effectively ‘selling’ company management various figurative ‘options’:
- The option to defer the coupon. Mitigant: dividends/shareholder returns must be suspended if coupons are deferred. Missed coupons are cumulative and often compounding. These issuers have solid ratings, sustainable cash flows and strong, flexible balance sheets. Stable and regular common dividends have been paid during the GFC, Eurozone Crisis and Covid
- The option to extend rather than calling the bond at the first call date. Mitigant: Bond structures ensure the notes lose equity credit after first call date – the key reason why they were issued in the first place – transforming them into potentially expensive senior debt
- The option, under certain circumstances, to call the bonds back early at or above par. Mitigant: reputational risk. These issuers are heavily reliant on accessing the bond market for funding
We believe – mainly due to the mitigants listed above – that these options are generally far ‘out of the money’ for most Corporate Hybrid bonds and provide investors with a significant opportunity.
In fact, as far as we are aware, there has never been a missed coupon on a Corporate Hybrid bond by an investment grade issuer. In addition, aside from certain extensions by real estate issuers in 2022/2023 – a sector we have long been cautious on – there is very limited history of call skips by investment grade Corporate Hybrid issuers. We expect these trends to continue in future.
From a portfolio standpoint, an allocation to Corporate Hybrids within a broader credit allocation increases diversification and efficiency. Recently, lower yields from senior bonds have led some investors to renew the search for yield. Corporate Hybrid prices and yields stand out in that context and offer a particularly attractive point today.
Are there enough issuers of corporate hybrid bonds to support diversification in a client’s portfolio? Are there any particular geographies/sectors etc. where issuance of corporate hybrid bonds is more (and less) common?
Since 2012, when the rating agencies standardised their methodologies, the Corporate Hybrid market has quickly grown to over $310bn equivalent in size. That is larger than the CoCo market and already ~70% the size of the European High-Yield market, yet many investors are still ignoring the opportunity set. We expect the market to continue growing by at least $20bn per year over the medium-to-long term on average, driven by a combination of:
1. Increasing capex needs
2. M&A
3. Weakness in certain sectors
4. Increasing issuance from the US
The catalyst for the latter has been a recent update by Moody’s who now assign 50% equity content, rather than 25%, for US Corporate Hybrid issues. The prevalence of preference shares in US capital structures – which rank below Corporate Hybrids in seniority – was the reason why only 25% equity credit was previously applied. Over time, we now expect US issuers to refinance their preference shares with Corporate Hybrids. The potential growth from this alone is well north of $100bn and that’s before we consider brand new entrants. Importantly, unlike preference shares, these US Corporate Hybrid bonds will be entering the major fixed income indices. In short, Corporate Hybrids can no longer be considered a niche asset class.
The universe itself is dominated by northern Europe from a geographic standpoint, and from a sector perspective is led by defensive, non-cyclical industries such as electric utilities and telecommunications. So versus traditional credit benchmarks and portfolios, Corporate Hybrids offer diversification away from financials, the US and USD, all of which typically drive the bulk of asset allocation.
Are there any particular macroeconomic circumstances in which corporate hybrid bonds can be particularly attractive?
In the short term, Corporate Hybrid Bonds tend to outperform Investment Grade senior bonds in periods of low and steady interest rates and spreads and particularly when interest rates and spreads are falling. They tend to outperform High Yield bonds in periods of spread widening. However, over the long run, at current spread and yield levels, corporate hybrid bonds look particularly attractive on a risk-adjusted basis, versus both investment grade and high yield bonds.
ENDS
Disclosures
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Corporate hybrid bonds are more volatile than senior bonds of the same issuers. However, credit default risk is the primary concern, which is partly mitigated by the strength of the issuers and is limited further through our security selection process. Corporate Hybrids are frequently confused with contingent convertible (Coco) bonds, which are issued by banks, but feature none of the write-down clauses or regulatory concerns of that bond type. Currency risk is hedged to within small tolerances.
Sustainability information from investee companies and third-party data providers may be incomplete, inaccurate or unavailable. As a result, there is a risk that we may incorrectly assess a security or issuer, resulting in the incorrect inclusion or exclusion of a security in the portfolio.
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By Kapish Patel, CFA, Co-Portfolio Manager Hybrid Bonds at Nomura Asset Management U.K. Ltd.
