Instruments: hybrids on song
The market for corporate hybrids, securities with equity and bond characteristics that are subordinate to senior bonds in a capital structure, has grown quickly in the past five years. Both issuers and investors are attracted to the market for different reasons.
For issuers, hybrids help to diversify their sources of funding, optimise their weighted average cost of capital, and improve balance-sheet strength and flexibility given that ratings agencies view the instruments as part debt, part equity. For investors, hybrids provide an opportunity to gain exposure to attractive corporate fundamentals and earn a return exceeding what is offered through senior bonds.
In the later parts of a credit cycle, amid rising defaults, some investors prefer to select instruments further down the capital structures of stronger issuers rather than invest in more senior securities of weaker companies at risk of not repaying their debt. Investors in the subordinated instruments should not only understand the risks endemic in adverse market conditions – such as extension risk, where issuers defer repayments, due to market conditions, and coupon cancellations – but also the incentives that serve to mitigate them. These include: the presence of a dividend stopper, which prevents the company from making distributions to shareholders unless the coupon on the hybrid is paid; the motivation to call the instrument in order to be seen in a more favourable light by ratings agencies; and whether the deferred coupons are cumulative, where skipped payments must still be paid if equity dividends resume, or, compounding, where interest is still paid on missed coupons, or both.
Case study: Enbridge
Comparing hybrid and senior securities involves analysing the relative value between three instruments: a hybrid, senior bonds with maturities similar to their first call date, and the longest dated security in the capital structure, of ideally 30 years or more. Deciding which one is most attractive depends on an investor’s judgement about which instruments will be called or not.
Enbridge, a Canadian oil and gas company, provides a good example. Its hybrid, which is callable in 2027, offers a spread of 240bps versus the shorter dated 2027 bond and 175bps in comparison to the longer dated 2046 senior bond. Given our positive fundamental view on the credit, we think it will be called and therefore put more stock in its valuation versus the 2027 bond or the 2046 bond.
Figure 4. Incoming call
Source: Bloomberg as at November 2019.
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