The market for hybrids – instruments that are part debt, part equity – has surged since 2013, with annual issuance increasing almost six-fold since 2012
It’s easy to see why: hybrids enable companies to reduce leverage and lower their cost of funding while substantially increasing the range of opportunities available to investors
To capture the attractive, differentiated returns offered by hybrids, investors must astutely manage key risks: call extensions, coupon deferrals and special events
With the corporate bond-buying programme initiated by Europe’s central bank resulting in greater hybrid returns relative to senior debt, we believe an allocation to the regional market is justified
In the low-growth, near-zero interest rate environment of today, investors seemingly face the worst of both worlds: low fixed-income yields and many equity markets trading at or near historical highs. In such conditions, they should look beyond the traditional bond-equity dichotomy: there is a spectrum of possibilities between the safety of sovereign bonds and the risk of stocks.
As global credit specialists, we seek the most attractive debt instruments in corporate capital structures. This mandate enables us to find many opportunities among the bonds, derivatives and loans issued by companies worldwide. Hybrid debt, which combines the scheduled interest and principal payments of fixed income with the loss-absorbing features of equity, also falls within our universe.
For issuers, hybrids offer some attractive features, such as enabling them to protect their credit ratings or improve the credit ratios for covenant purposes. For investors, hybrids can provide a rewarding
risk-adjusted return – but as always, achieving this requires attention to the details.
In this issue of Spectrum, we discuss the rapid expansion of the hybrid market, the attraction of the instruments for investors and issuing companies, and the key risks and sources of return premium that investors must assess. We also provide two case studies to demonstrate our investment approach to the market.
A growing attraction
After a post-financial crisis slump, the European hybrids market has expanded enormously in the last three years, providing investors with a greater range of offerings.
Before the crisis, European hybrid issuance peaked at €6.3bn in 2005 before plummeting to almost nothing in 2009. However, since 2013 European companies have issued more than €30bn in hybrids each year and the value of corporate hybrids outstanding now outweighs that of more established convertible bonds (see figure 1).
Hybrid capital, as the name suggests, combines two distinct species of corporate funding into a structure that, while containing recognisable elements of debt and equity, is a unique composite. For companies,
Figure 1. On a tear: hybrid issuance has surged since 2013
Source: Hermes Credit, J.P. Morgan as at July 2016.
hybrids offer a flexible capital-raising solution that helps to achieve a better balance between the cost of funding and leverage. In short, hybrids are more favourably treated by credit-rating agencies and accounting standards, such as those set by the International Financial Reporting Standards (IFRS), than debt and have a lower cost than equity.
At a more technical level, hybrids can improve leverage when expressed as debt/enterprise value (EV) with a moderate increase in the weighted average cost of capital (WACC). Figure 2 shows that when hybrids are substituted for debt, the company’s leverage ratio decreases – from 50% to 45% in this example – while its WACC increases slightly to 5.6% from 5.4%. Likewise, swapping a portion of equity for hybrids can help improve a company’s WACC with a lesser increase in leverage compared to what would be incurred by raising debt.
Figure 2. How hybrid instruments can improve the issuing company’s capital structure
* For illustrative purposes tax. The tax rate applied in this example is 40%; the costs of debt, hybrids and equity are 3%, 6%, and 9% respectively.
** Hybrids are 50% equity and 50% debt.
Source: Hermes Credit
A number of other benefits flow to companies that include hybrids in their capital structures. The instruments can help protect corporate credit ratings, due to the ways in which ratings agencies rank hybrids in assessing a company’s creditworthiness, while also improving balance-sheet debt dynamics, given that the IFRS deem hybrids to be 100% equity, which helps to ward off potential covenant problems.
Furthermore, hybrids can provide tax benefits to the issuing firm through deductible interest payments, while their ability to defer coupons or extend maturities beyond the call dates also provides capital stress relief.
However, we treat corporate hybrids as debt and debt service payments as cash interest expense. This is because outside of severely stressed scenarios, our base case is that companies will continue to service their debt obligations.
Setting the standard
This rapid growth has coincided with efforts to standardise hybrid instruments. Issuers have realised that standardisation – making hybrid offer documents more uniform and comparable – should make it easier to compare prospective investments and thereby attract new investors to the market. Currently, 95% of the market is of the 2012-or-later vintage, and features some common structures. For example, a typical hybrid issue today would be structured as follows:
- A fixed coupon to be paid until the first call date
- After the first call date, the spread is re-set to its level at the time of issuance, and a margin is added (for example, the five-year mid-swap rate) for five years
- Beyond five years, a small ‘step-up’ (for example, 25 bps) is added with the new reset spread based on the current margin for another 15 years
- After 15 years, the spread is reset to match the spread at the time of issue, with a margin and larger step-up (such as 75-100 bps) added until maturity
Figure 3. Model hybrid: the typical recent structure of the instruments
Source: Hermes Credit. Five-year mid-swap levels are illustrative.
Recent hybrids also include the option to defer coupons, which are cumulative and compounding and have to be paid in full once dividend payments are reinstated. Unlike most high-yield bonds, however, hybrids do not feature debt incurrence, restricted payments baskets, permitted investments or protective liens covenants, and this must be taken into account by investors.
The growing size and quality of the hybrid market has significantly expanded the investable universe for credit investors. When added to the Bank of America Merrill Lynch European currency non-hybrid high-yield index, the number of issuers increases by 20% and the volume of outstanding instruments expands by almost 40%. This enhances the liquidity available to European high-yield bond investors at a time when this is a major concern. However, despite the benefits they provide for investors and issuing companies, risks lurk in the hybrid structure that should be monitored.
Why you need to make the right call...
While hybrids are a flexible investment tool for issuers and an attractive, differentiated source of returns for investors, they are also subject to instrument-specific risks. The three most important structural risks of hybrids are extension, coupon deferral and special-event calls.
Extension risk refers to the potential non-call of the security – that is, the issuer decides not to pay back investors on the expected call date. The level of extension risk in any hybrid offering can be determined by thoroughly investigating the senior part of the capital structure and expected future credit spreads.
First, if a company’s credit profile significantly deteriorates to the point where spreads on its hybrids match those on its senior debt, it may not be economical to call the securities. In these circumstances it is also important to assess the likelihood of whether the company will still need the equity credit. However, with serious corporate reputational damage at stake, there have been very few non-call cases in the European hybrid market to date.
Second, the ability of a company to defer coupon payments at its discretion creates another risk for investors. If coupons on hybrids are deferred, the company has no ability to pay dividends. The important caveat here is that in most structures the coupons are cumulative and compounding, meaning that if the firm decides to start paying dividends again it will have to pay all deferred coupons along with any interest accrued. As a result it is very expensive to defer coupons, and companies would be reluctant to do so unless they are in real distress. There have been no cases of coupon deferral yet.
Aside from non-call and coupon deferral risks, credit investors also have to carefully scrutinise the fine print on hybrid offer documents to understand the risks posed by any special-event calls. These are particular instances where the issuer has the option to call the hybrid bonds at a price that is normally very close to par. While the following list is not exhaustive, common clauses that trigger a special-event call address changes in:
- The ratings methodologies used by rating agencies
- Regulatory accounting treatments
- A change of control in the ownership of a company
- Tax treatments
These risks are particularly acute for securities trading significantly above par.
However, a change in a rating methodology constitutes the biggest call risk facing hybrids – historically, we have seen some significant moves by ratings agencies. For example, since July 2013 Moody’s has stopped assigning equity credit to non-investment-grade issues. And in some cases, special-event calls have led to significant losses for investors, particularly when issuers decide to exit the hybrid capital market altogether.
Understanding and managing the risks of hybrids is, of course, essential for credit investors. We thoroughly investigate both the risks and potential rewards of hybrids to develop a relative-value (RV) measure to assess the attractiveness of a specific hybrid compared to other instruments within the same capital structure. This metric analyses the return profile of hybrids, which can be divided into four components (see figure 4).
The first two cover rates and senior spread, which represent the compensation paid for taking the credit risk at the senior level. Digging a little deeper into the structure, we also consider the subordination premium. This provides compensation for a lower recovery in the case of default, and can be estimated by adjusting the senior spread for the difference in expected recovery between senior and subordinated instruments. Finally, the structure premium reflects the key risks of hybrids discussed above – extension risk, coupon-deferral risk and special-event calls. It is by far the largest component of total return for a hybrid instrument.
In addition to understanding the risks and return premiums of the instruments, investors must also remain aware of the broader economic and financial factors underpinning the hybrid market.
Figure 4. Sources of return from hybrid instruments
Source: Hermes Credit.
While hybrids are flexible investment tools for issuers and provide an attractive, differentiated source of return for investors, they are also subject to instrument-specific risks – particularly extension, coupon deferral and special-event calls
...at the right time
A key factor for credit markets this year is the European Central Bank’s (ECB’s) corporate sector purchase programme (CSPP), which began in June. The corporate bond-buying initiative is an extension of the ECB’s existing quantitative easing (QE) programmes.
The investment-grade market rallied on the announcement of the new programme in March and has remained at elevated levels since. But its direction from here is unclear now that the CSPP is live. Our view is that Europe has priced through fair value, indicating that the market is less attractive relative to other regions. Another consideration is that recovery rates will be dramatically lower than in the past, as the artificial boost of QE, which has resulted in lower refinancing costs, has kept some companies afloat longer than what would have otherwise been expected.
Since the CSPP launched, senior spreads have outperformed hybrids (see figure 5). In our view, the supply of hybrids will temporarily become constrained if their pick-up relative to senior debt continues to exceed the historical norm. Simultaneously, a higher pick-up results in a higher structure premium, making hybrids attractive for investors. For this reason, in addition to the inherent investment benefits of the instruments, we believe that an increased allocation to the European hybrid market is currently justified. Still, the idiosyncratic risks of each hybrid instrument require careful analysis.
Figure 5. European senior debt is outperforming subordinated debt
Source: Bloomberg, Hermes Credit as at July 2016.
Solvay: a careful mixture
Solvay is a Belgian specialty chemical company with exposure to positive secular trends in the global automotive, aerospace, smart devices and healthcare industries.
The business has a strong track record in the growing speciality chemicals segment while successfully managing the financial risks inherent in higher debt levels, which has enabled it to maintain an investment-grade credit rating over the long term. Solvay has used hybrid instruments to optimise its capital structure, with the equity credit helping to sustain its rating.
The company is exposed to some weak areas in the chemicals market like acetate tow, non-conventional oil and gas, and some parts of the technology sector. It also has an aggressive acquisition policy. But we are confident that Solvay’s diversification and emphasis on stabilising leverage helps
to mitigate these risks.
In our view, the structural risks of Solvay’s hybrids are mitigated by a number of dynamics: the economic logic of refinancing the instrument at its call date, the importance of dividends for chemical companies, and our expectation that hybrids will remain a permanent part of the company’s capital structure.
Given these favourable credit characteristics, we expect Solvay’s hybrids to outperform its senior debt in the coming years as the company implements its plan, with a pick-up of 350bps-375bps, which is in the context of the market.
BHP: solid finances support down-under firm’s credit
Melbourne-headquartered BHP is one of the leading natural resources companies in the world, with exposure to a diversified portfolio of commodities including iron ore, petroleum, copper, alumina and manganese.
Recently, BHP’s petroleum assets have not been a good diversifier, but in our opinion the exposure is still positive as dynamics within oil and gas markets can be different compared to metals. The majority of BHP’s assets are located in regions and countries with low geopolitical risk, like North America and Australia. In our analysis, BHP is well-positioned to withstand the current volatility in commodity markets due to its top-tier asset portfolio and positive positioning on the cost curve.
In the current commodity downturn, BHP’s management has moved to protect the company’s strong balance sheet and credit rating by reviewing its dividend policy, reducing capital expenditure and accelerating cost cuts.
We think the risks to the structure premium in BHP hybrids are mitigated by:
- Management’s commitment to keeping a strong credit rating
- The importance for BHP of having access to capital markets and a strong reputation, given the potential need to raise capital to fund future growth
- Expectations of dividend payments from investors in mining companies, which lowers the risk of BHP deferring coupons
Typically, hybrids are seen as being more appropriate for companies less exposed to economic cycles, such as utilities. However, we think there is a case for investing in the hybrids of cyclical businesses which have transparent financial policies and strong balance sheets – like BHP.
With more than 300bps in pick-up relative to senior spreads on the company’s cash bonds and credit-default swaps, we think BHP hybrids are the most attractive instrument in its capital structure and also compare favourably with other investment-grade hybrids in the market.
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