By Julian Marks
When an apparently sleepy, decade-old market suddenly explodes into life, it is natural to ask what that means for investors.
That is what happened to non-financial corporate hybrid securities during 2013-14 when, after seven years edging its way towards $20bn, the market exploded by well over 300%. Today, 57 companies have issued more than $120bn worth of notes, with the potential market size being seen as anything up to $800bn.
Corporate hybrid debt has characteristics of both debt and equity. It is subordinate to senior debt, but it is senior to equity. It pays coupons, but the issuer can stop paying those coupons without defaulting – although there are significant incentives not to do so. Like equity, these securities are either extremely long-dated or perpetual; but issuers are strongly incentivised to call them back at the first call date, which is typically 5-10 years from issuance.
In return for these characteristics, corporate hybrids offer extra yield relative to investment-grade senior bonds, which accounts for the evident investor demand. But the likelihood of issuers using the flexibility available from these securities is very small. Hybrids are almost certain to pass their lives as no-frills, high-yielding, 5 or 10-year subordinated debt.
The case for investors
The sheer scale of recent issuance means investors can no longer ignore this asset class: it already accounts for more than 3% of the BoAML Euro Investment Grade Corporate Credit Index. The good news is it also presents compelling value.
First, consider the quality of the issuers. Nearly all are investment-grade, which should come as no surprise given the preponderance of stable utilities and telecoms, while two-thirds of issuance comes from companies in the UK, Germany and France.
This quality is important. We assume zero default recovery, as opposed to a 35%-40% recovery from the same issuer’s senior debt. Rating agencies recognise the risk by rating hybrids typically two or three notches lower than the same issuer’s senior unsecured debt. The average rating is BAA2/BAA3, or BBB/BBB-.
How much spread are investors paid for this? At the end of January, hybrids yielded almost 400bp more than the average investment-grade bond. We believe spreads more than compensate for the subordination: even after factoring in a premium for that risk, we estimate there are more than another 100bp of spread available from hybrids relative to senior.
The case for issuers
Correctly-structured, rating agencies will give hybrids some equity credit. This means, uniquely, hybrids enable companies to raise capital without diluting shareholders, while at the same time protecting credit ratings – because the agencies count them partly as equity and partly as debt.
Furthermore, coupon payments on hybrids are not only deferrable, but also tax deductible. That means a hybrid issue awarded the typical 50% equity credit by a rating agency will be cheaper than the same amount of capital structured as half-debt and half-equity, given current pricing.
This should provide sufficient incentive for companies to issue as much hybrid debt as they can.
Do issuers defer coupons or refuse to call?
Clearly, if a borrower can suspend payments of bond coupons for as long as five years without defaulting, as it can with a hybrid, the incentive to do so is slightly higher. In general, the quality of hybrid issuers mitigates coupon-deferral risk. Moreover, reputational damage would be a heavy price for an issuer to pay to save such a small proportion of its overall dividend and interest payments.
Even if the issuer were tempted, this is not a free option. Hybrid documentation generally states a company that stops paying the coupon is not allowed to pay equity dividends; or that paying a dividend obliges it to pay the coupon. Coupon deferral will only ever be a very last resort. We cannot find any example in the history of non-financial corporate hybrids of missed coupons.
Additionally, hybrids are generally issued on the premise they will be called at their first-call date, which is usually 5-10 years after issuance. However, they are designed to remain in place should issuers get into trouble. Again, the inevitable reputational damage acts as a big incentive not to extend and hybrids are structured to mitigate extension risk still further.
A higher yield alternative
We are on a road toward a new asset class, and are well-compensated for the journey’s occasional volatility. Even after accounting for more than 100bp as a premium for subordination, coupon deferral and extension or early-redemption risks, the market still offers a further 100 basis points or more of residual spread, on average.
These securities offer a genuinely high yield, in a low-rate environment. We believe spreads are likely to compress as the asset class becomes better-understood and more widely-held.
Julian Marks is manager of the Neuberger Berman Corporate Hybrid fund