Dequity: are hybrid bonds the answer to investors’ prayers for yield?

23 Nov 2016

Hybrids also offer some attractive features to issuers, enabling them to protect their credit rating or improve their credit ratios for covenant purposes. Take Spain’s Telefonica for example: the mobile communications giant includes nearly €5bn of hybrids as equity on its balance sheet for reporting purposes. The interest expense flows through the consolidated statements of changes in equity as retained earnings. On the cash flow statement – the most important statement to debt investors – Telefonica does not run the cash payments through the ‘cash generated from operations’ segment, but rather in the financing section, where the cash flow statement picks up dividend payments.

Because Telefonica accounts for its nearly €5bn in perpetual bonds as equity, they exclude them from the debt component of the all-important financial leverage ratio (net debt-to-EBITDA) – a measure of financial risk – which deflates that number. Meanwhile, the rating agencies do not classify these equity-like debt securities as 100% debt.

Despite the sector’s rapid growth, the first quarter of 2016 proved to be a testing time for the European hybrid corporate bond market. New issuance stalled and bond spreads widened as market volatility has put investors in a risk-off mode.

Over 14% of the Markit iBoxx € Non-Financials Subordinated index is composed of hybrid bonds issued by Volkswagen, the largest issuer in the index by weight. The German car maker saw its bond spreads flare up on the back of an emissions scandal last September, as the company faced drawn out litigation charges and reputational damage.

French oil group Total meanwhile, the next largest issuer of hybrids by weight, has struggled to deal with deteriorating oil and gas prices over the past year, forcing the company to restructure parts of its business. Its hybrid bonds currently trade at just under 400bps over German bunds.

But while hybrids continue to underperform their senior European corporate counterparts, the market outlook has brightened over the past few months. “There were lots of different spurious
drivers for the underperformance in the 12 months leading up to the end of February,” says Neuberger Berman global credit portfolio manager, Julian Marks. “But I think the performance since then is the result of the valuations since then looking very attractive versus fundamentals.”

Hermes Investment Management co-head of credit, Fraser Lundie, agrees. “Since the ECB’s CSPP launch in June, senior spreads have outperformed hybrids,” he says, but adds: “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.”

So a large market, offering significant income in a yield starved market – what’s the catch?

“The three most important structural risks of hybrids are extension, coupon deferral and special-event calls,” says Lundie.

Extension risk refers to the potential noncall 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.

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