This summer’s decision by the Bank of England to buy corporate bonds, following the path of the ECB’s CSPP, perpetuates the low-growth, near-zero interest rate environment of today. Investors now face being crowded out of “eligible assets”, and top of the list of places to go for spill-over opportunities is in the corporate hybrid market, writes Fraser Lundie, Co-Head of Credit at Hermes Investment Management.
The European Central Bank’s (ECB’s) corporate sector purchase programme (CSPP), which began in June, now joined by the Bank of England, will be a key technical driver for the market through the remainder of 2016. Since the CSPP launch, senior spreads have outperformed hybrids (figure 1). In our view, if hybrids remain at above-historical pick-up from seniors, this will constrain supply, while the higher ‘structure premium’ makes them attractive for investors.
For issuers, hybrids offer some attractive features, such as enabling them to protect the credit rating or improve the credit ratios for covenant purposes. For investors, hybrids can provide a rewarding risk-adjusted return. This apparent win-win for issuers and investors alike has seen to the rapid expansion of the hybrid market. Indeed, since 2013 European companies have issued more than €30bn in hybrids each year, and the value of corporate hybrids outstanding now outweighs the entire European convertible bonds market.
So a large market, offering significant yield pick-up in a yield starved market – what’s the risk? 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. Secondly, the ability of a company to defer coupon payments at their 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. Thirdly, 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. Common call clauses include changes in the ratings methodologies used by rating agencies, regulatory accounting treatments, a change of control in the ownership of a company, and tax treatments.
If one can become comfortable with these risks, the return profile of hybrids can be attractive, but how can you decipher it? Essentially it can be divided into four components. The first two cover rates and ‘senior spread’, which represent the compensation for the credit risk at the senior level. Further down the structure, we also consider the ‘subordination premium’. This provides compensation for a lower recovery in case of default. Finally, the ‘structure premium’ reflects the key risks of hybrids discussed above, and is by far the largest component of total return for a hybrid instrument.
Still, the idiosyncratic risks require due care. An example we like and hold is Solvay, a Belgian specialty chemical company. It has exposure to the growing specialty chemical segment, as well as positive secular trends in the automotive, aerospace, smart devices and healthcare industries globally. Further, it emphasises stabilising leverage post aggregate acquisition history, while the structural risks of Solvay’s hybrids are mitigated by the importance of dividends for chemical companies, and our expectation that hybrids will remain a permanent part of the company’s capital structure.
Given the favourable credit trajectory of the credit, we think that as the company delivers on its plan over the next few years, the hybrid part of the capital structure will outperform senior – part of a broader theme we think is worth recognising at this juncture.