By Jens Vanbrabant
Credit investors have long been familiar with subordinated financial bonds but the key features of corporate subordinated issuances are less well known. Following €24bn of issuance year to date the overall hybrid market for European corporates has doubled in size in 2013 and is now approximately €50bn.
The main attractions for issuers are that under IFRS rules they can count as 100% equity and that rating agencies treat a portion, generally 50%, of a hybrid bond’s nominal as equity. Given the low interest rate environment, it is no surprise hybrid issuance has boomed as issuers can now achieve these advantages by paying a modest all-in yield.
In exchange for the so called “equity credit”, rating agencies require these securities to have equity-like features. They are deeply subordinated, ranking junior to unsecured debt in the event of insolvency and there is no limitation on the issuance of more senior debt above the hybrid; making them particularly vulnerable to corporate re-leveraging and LBO risk. In most cases, coupons can be deferred at the discretion of the issuer for up to five years before constituting a default event. So called “replacement capital covenants” (RCC) also require issuers to redeem existing hybrids with proceeds from equity or a newly raised hybrid. This combination of features means that corporate hybrids are typically rated two notches below senior unsecured bonds issued by the same issuer.
Since 2010, the typical structure is a perpetual non call five. Despite this, hybrids are not overly sensitive to changes in yields as nearly all European corporate hybrids are pricing to the first call date. This happens for a few reasons. Firstly, the issuer is economically incentivised to redeem the bond at the first call date due to a built-in coupon step up mechanism and also because rating agency equity credit is removed as the RCC kicks in, providing a call incentive to avoid having expensive debt that adds to the company’s leverage multiple. Secondly, the issuer will want to protect its reputation as a responsible bond market citizen by calling the bonds. As a result, it is only when an issuer’s credit quality deteriorates significantly that perps start to price to maturity with much larger duration and therefore with much more to lose following incremental increases in yield.
A factor worth highlighting is that as the asset class has evolved, so have rating agencies’ methodologies. Moody’s last revised its approach for determining equity benefit in July, making hybrids issued by HY issuers ineligible for equity credit as long as the issuer remains rated sub investment grade. S&P refined its methodology in April, making it more difficult for new and existing hybrids to attain 100% equity credit. Issuers typically protect themselves by including rating methodology event calls giving them the option to redeem early if the equity benefit of the instrument allowed by rating agencies deteriorates.
So how do investors actually decide whether or not to buy hybrids of different issuers and vintages? A bottom up assessment of the issuer’s financial strength and the hybrid’s covenant package is most important. Then, a relative value assessment is needed. Previously, metrics such as the spread per turn of leverage or the multiple at which the hybrid was trading versus the issuer’s senior debt were often used. As the market has matured however and comps are available across most industries, most investors now prefer to compare the yield or spread to that of other outstanding hybrids. Finally, the impact of the bond on a fund’s risk profile needs to be considered as corporate hybrids are volatile instruments due to their deep subordination.
By Jens Vanbrabant is lead portfolio manager at ECM Asset Management
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