Corporate Hybrids: a forgotten asset class?
Based on a rigorous fundamental and technical analysis of the specific clauses of each issuance and on a selection of high-quality issuers according to our analysis, our perspective on hybrid debt can be summarized in one sentence.
In Summary :
- A relatively confidential asset class, it nevertheless has several advantages:
- Yields that could be attractive, for issuers that often have a high-quality rating.
- Less cyclical issuers than High Yield bonds².
Representing 6% of assets under management in bonds, the hybrid market remains discreet.
Unlike lower-rated debt, which accounts for 7.7% of the market, flows are relatively steady over time.
Source : Morningstar as of 08/31/2023
Hybrid and senior debt: What are the differences?
Attractive return1 compared with senior debt
There is a repayment schedule for creditors in the event of bankruptcy. Hybrid debt may be repaid after senior debt, which is why its yield may be higher. This is known as subordination risk. In addition to this risk, there is the ability to postpone the final reimbursement date.
Since they are issued by issuers of high credit quality, hybrid debt offers the possibility of enhancing the performance of a credit portfolio with controlled risk.
Source: Groupama AM-Bloomberg as of 07/19/2023
The additional return (risk premium) results from additional risks: subordination and extension risks.
Instantaneous performance is not synonymous with future performance. Returns are not guaranteed and do not exempt investors from the risk of capital loss. These examples are provided for illustrative purposes only. This information does not constitute, in whole or in part, an investment advisory service, an offer or a personalized recommendation for the investment products or services presented.
•… For an investor willing to accept fewer guarantees than a Senior bond.
Hybrid debt, perceived by rating agencies to be 50% equity and 50% debt, is halfway between equities and senior bonds, hence the name hybrid. Consequently, its shares numerous similarities with these two asset classes.
- On one hand, they offer a fixed coupon and allow for an optional, but likely early repayment (Call). On the other hand, they can distribute discretionary coupons linked to dividend distribution.
- The difference in maturity between hybrid and senior bonds lies in the fact that hybrid bonds can have a longer, even perpetual lifespan, whereas senior bonds have a predetermined maturity date at which the principal is fully repaid.
- The possibility of a gradual, pre-determined increase in credit premiums at specific intervals, which represent a sort of guarantee for the investor if the issuer fails to exercise its call.
- If a credit event occurs, corporate hybrid debt is reimbursed after senior debt.
Hybrid debt, High Yield debt: Which instruments to choose to capture yield?
For an investor aiming to maximize his returns, two potential solutions are available:
- To lower the issuer’s credit rating, and therefore being exposed to the lowest-rated issuers (High Yield bonds). This could lead the investor to potentially encounter an increased risk of issuer default.
- To invest mostly in Investment Grade issuers yet consenting to accept subordinate downgrades by investing in hybrid bonds. Although the risk of default would be lower, in case of default, the investor would not be prioritized for reimbursement.
In a complex environment, marked by the end of the Covid aid, by the monetary tightening by central banks to fight inflation by slowing down the economy and by the existence of geopolitical risks and disruptions in supply chains, we believe that holding a hybrid debt, whose issuers will on average be less sensitive to insolvency risk is an interesting option according to our analysis.
The valuation levels are currently in favor of Hybrids, with spread levels that have tightened less than those on High Yield⁴:
Right scale: absolute risk premiums (in basis points)
Left scale: relative risk premiums hybrid vs High Yield (in basis points) Source: Groupama AM-Bloomberg as of 09/12/2023.
Outlook for the fourth quarter of 2023:
- The primary market should gradually return to a higher rate of issuance to meet a major refinancing requirement according to our analysis. With almost 23 billion euros of bonds reaching the first call date at the end of 2024, the recall of the issuances remains the option chosen in most cases.
- Issuance momentum should also be boosted by the financial flexibility offered by hybrid corporate bonds. Positioned halfway between equity and debt, hybrid debt enables companies to strengthen their financial positions without compromising their ratings by limiting the level of long-term debt.
Hybrid debt at Groupama Asset Management:
Based on a rigorous fundamental and technical analysis of the specific clauses of each issuance and on a selection of high-quality issuers according to our analysis, our perspective on hybrid debt can be summarized in one sentence:” With an issuer’s rating equal to that of senior bonds, corporate hybrids bonds can enhance performance and diversify a credit portfolio” Guillaume LACROIX, manager of the G Fund Hybrid Corporate bonds created in 2019.
1Yield to maturity at issuance are not guaranteed rates and do not exempt the investor from a risk of capital loss
² High Yield rating: rating less than or equal to BBB-. High Quality rating: rating strictly above BBB-.
³ At 08/31/2023
⁴The additional return (risk premium) results from additional risks: subordination and extension risks. (Risks are detailed on the next page).
Written on 09/25/2023.
Credit risk: although this risk is fairly low for issuers with a high Investment Grade rating (A/A-/BBB+), it is higher for BBB- issuers in times of crisis.
Interest-rate risk: the price of hybrid securities with a long first call date is more sensitive to interest-rate fluctuations.
Volatility risk: corporate hybrids are positively correlated with equity markets. During periods of risk aversion, equity prices fall and the credit spread on hybrids widens, leading to a fall in their price.
Subordination risk: hybrids are subordinated debt instruments. This means that their rating is, on average, 2-3 notches lower than the senior debt of the same issuer (hybrids are often rated HY).
Extension risk: an issuer may decide not to call the hybrid on its first call date. In particular, this type of event can occur when the issuer’s rating is downgraded to HY, reflecting a deterioration in its credit profile since issue. However, such cases have been rare since 2013.
Deferral of coupon payment: an issuer may decide not to pay one or more coupons on its hybrid(s). This risk is very low (lower than extension risk) during periods of economic growth, but this scenario may arise if the issuer encounters severe liquidity difficulties. This scenario only materializes when shareholder remuneration is suspended. Such an event would seriously damage the issuer’s reputation, reducing its ability to borrow on the bond market in the future.
Early redemption risk: again, this is at the issuer’s discretion. Specific clauses in the issue prospectus may provide for the triggering of an early call at the 101% price, in the event of changes in rating agency/tax/accounting methodology. As a result, it will have an impact on hybrids trading at a high market price. But there is no change in methodology (from the rating agencies) as long as the issuer replaces a hybrid recalled at the first call date with a new hybrid.
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