Flash G Fund Hybrid Corporate Bonds
In fact, hybrid bonds are considered by rating agencies to be partly equivalent to equity (50% equity / 50% debt).
Characteristics of “hybrid” bonds
As a reminder, a hybrid bond is:
- a debt instrument issued by a non-financial company
- with a very long maturity, or without maturity (perpetual bond or “perp”)
- with the possibility for the issuer to redeem the debt after a fixed number of years (generally after 5 years).
Hybrid bonds combine key characteristics of both:
- conventional bonds – fixed coupon, optional call date etc.
- and equity – distribution of discretionary coupons, possibility of no maturity date (perpetual bond) etc.
In fact, hybrid bonds are considered by rating agencies to be partly equivalent to equity (50% equity / 50% debt) .
These instruments cannot be converted into equity – there is no trigger nor loss absorption – except, as with senior debt, in the case of default.
Finally, the coupons are deferrable. but they cannot be cancelled.
The main attraction of hybrid debt instruments for investors is the fact that they provide yield pick-up than the senior debt instruments from the same issuer.
In our hybrids fund G Fund Hybrid Corporate Bonds, we invest only in bonds issued by Investment Grade (IG) issuers(1) with historically very low default probability.
Impact of a global health crisis
Investors were caught off guard by the spread of COVID-19 across the planet. The pandemic led to the shutdown of the entire economy during a major part of the spring. As a result, most companies abandoned all their normal references and benchmarks. The slumps in economic activity during the 2nd quarter were quite simply historic.
Capital flows were diverted massively away from the risky asset classes. Hybrid debt did not escape this generalized correction or the dislocation of the credit market. However, the levels of market correction were in many cases out of all proportion to the solidity of the companies concerned and to their liquidity and their ability to rapidly adjust their cost bases.
In response to the powerful support of governments and the central banks aimed at preventing company bankruptcies wherever possible, the financial markets have recovered their senses and progressively restored normality, as is witnessed in the spreads offered on the hybrid debt market, even if these spreads nevertheless remain at much higher levels than before the crisis.
Reawakening of the primary market in the hybrid debts universe during the spring
After many long weeks without any new issues during March – April, the hybrid debt market reopened to vigorous investor appetite, notably Swiss company Firmenrich or Spanish company Repsol.
The primary market accelerated dramatically in June, boosted significantly by the launch of the biggest hybrid issue ever observed by British Petroleum (10 billion euros in 5 tranches):
Data as on 27 July 2020. Source: JP Morgan.
So, the year 2020 can be expected to resemble 2015, when issuers, especially in the energy sector (with its credit profile downgraded following the massive falls in energy prices), had taken the decision to issue hybrid instruments to reinforce their ratios.
Finally, the succession of new hybrid issues was brought to a close before the summer break by TenneT, the Dutch electricity transmission system operator, with a green bond of one billion euros (in response to overall investor interest of about 2.5 billion euros). This bond aims to develop renewable energies, especially wind turbines, in the Netherlands and Germany.
This surfeit of new issues ultimately impacted the hybrid debt spreads during June, when they again rose above the mark of 200 basis points compared to senior debt.
Data as on 31 July 2020. Sources: Credit Suisse, Bloomberg.
Issuers continue to exercise their call option
We consider that the calls exercised by issuers that were particularly badly hit by the crisis (Accor, Suez and Volvo) will help to reassure investors, who will now envisage the next call-dates with greater serenity.
The problem of State aid: little impact for our investment universe, and even less for our fund
The update to the rules concerning State aid in the context of COVID-19 published by the European Commission on 8 May caused a stir on the hybrids market. This provision triggered volatility on issuers such as Deutsche Bahn and EDF. This is because the injection of State aid for these issuers could lead to suspensions of coupon payments, pending full redemption of the COVID-19 recapitalization measures.
However, we consider that this risk should be put into perspective:
- Numerous exemptions are provided for green investments and carbon neutrality (the Deutsche Bahn hybrids are green bonds);
- In our opinion, very few issuers in the hybrid debt universe are concerned by this risk of coupon suspension, except for Lufthansa (we have not had any exposure to this issuer). Also, we do not believe that EDF and Deutsche Bahn, which are already held by their respective States, are concerned by this risk;
- The text clearly states that aid provided by the State must be remunerated. So, once this remuneration is paid, coupon payment is no longer non-mandatory but mandatory;
Reinforcement of the sectors relatively less impacted by the COVID-19 crisis in early spring
The massive flight of capital from corporate debts impacted the entire market indiscriminately, with no real distinction between individual sectors, even though the Utilities and Telecommunications sectors seem to be relatively spared by the current crisis.
Moreover, these sectors already benefit from State investment in their equity. The issuers of these sectors still have access to the primary market and are purchased by the ECB.
Consequently, we have reinforced our positions in the sectors of Telecommunications (for example KPN, Vodafone and Orange) and Utilities (for example Vattenfall).
And subsequent reweighting of the more cyclical sectors
The real estate sector has been significantly disrupted during the crisis. In our opinion, residential real estate will fare better than commercial or office real estate, and so we took advantage of the spread widening to make repeated purchases of instruments issued by Vonovia, which specializes in residential real estate.
During May, we increased our allocation in more cyclical sectors, such as the automotive and energy sectors. We therefore reinforced our position on Volkswagen, anticipating an improved market environment due to the various specific stimulus plans for the sector, which will naturally benefit this issuer. In the energy sector, we have reinforced Total and Repsol. This is because we consider that the lifting of confinement measures should lead to a more positive outlook.
Portfolio breakdown is as follows:
Data as on 4 August 2020. Source: Groupama Asset Management.
Performance and volatility
Data as on 31 July 2020. Source: Bloomberg.
The net YTD performance of the fund G Fund Hybrid Corporate Bonds (I-C share, ISIN code LU2023296168) is -3,10% (as on 31 July 2020).
The overall hybrid debt universe (according to the Credit Suisse European Corporate Hybrid Index) has outperformed this fund, because of the very high concentrations on more cyclical sectors, such as the energy sector and Volkswagen, which have rebounded powerfully since the end of March.
Also, many of these issuers are classified as Major ESG Risks by our analysts, and so we do not wish to be heavily exposed to these companies. For information, the performance aim of the fund is to outperform the universe of Senior Corporate Investment Grade debt, not to outperform the hybrid debt market. Consequently, we have adopted a flexible, non-benchmarked approach, which enabled us to position ourselves prudently at the beginning of 2020 and therefore to be less badly hit than the overall hybrid universe during the crash of February – March.
Sources: Groupama Asset Management. Fund launched on 7 October 2019 G Fund Hybrid Corporate Bonds I-C – EUR: LU2023296168. Indexes expressed in euros. These indexes are quoted purely for information purposes and do not constitute benchmarks for the fund. Data as on 31 July 2020. Volatility calculated on a daily basis
Past performance is not a reliable indicator of future performance
The main risks associated with the fund are interest rate risk, credit risk, risk intrinsic to hybrid or subordinated debt instruments and liquidity risk.
The hybrid debt class has already rebounded from its lowest levels. However, the journey back to normalization is far from over.
With the investment environment becoming less tumultuous and remaining largely assisted by the central banks, and with a spread of 220 basis points compared to Investment Grade senior debt, the attractiveness of this asset class remains intact.
Investor interest in corporate debt instruments is not expected to decline over the summer. The reduced activity on the primary market, both for conventional senior debt and hybrid debt, should lead to a spread narrowing and therefore higher performance of the hybrid asset class.
Consequently, we aim to position the portfolio more offensively, by increasing our exposure to instruments with longer call-dates (longer than 5 years) and shedding instruments with shorter call dates (2 years and less).
(1) Investment Grade: high credit quality according to the Rating Agencies (minimum rating BBB-). High Yield: credit rating strictly below BBB- by the Credit Rating Agencies.
This document is not intended for “non-professional” European Union investors, as defined in “MiFID” (EU Directive 2004/39/EC dated 21 April 2004) or any other local regulation. Similarly, in Switzerland, this document is not intended for investors not classified as “qualified investors” under the applicable legislation. As a general rule, this document must not be transmitted to private clients or individuals as defined in any legislation, nor to “US Persons”.
This document contains information concerning G FUND – HYBRID CORPORATE BONDS, a compartment of G Fund (also referred to as “the SICAV”), a Luxembourg-based undertaking for collective investment in transferable securities (UCITS), covered by part I of the Law dated 20 December 2002 and constituted in the form of a “SICAV”(Société d’Investissement à Capital Variable – a European publicly traded investment company structure for open-ended funds). The SICAV is registered with the Luxembourg Trade and Companies Register under number B157527. Its registered office address is 5, allée Scheffer, L-2520 Luxembourg. G Fund was authorized for trading by the Luxembourg financial authority CSSF (“Commission de Surveillance du Secteur Financier”).
Investors are advised that not all compartments of the SICAV are necessarily registered, authorized for commercialization or accessible to all investors in all jurisdictions. Before subscribing to a compartment, the client must take due note of the complete prospectus of the SICAV and of its latest annual and half-yearly reports and its articles of association. These documents are available free of charge at the registered office of the SICAV or at the registered office of the authorized representative accredited by the competent authority in each jurisdiction concerned.
Investment in the compartments of the SICAV involve risks. Investors must fully inform themselves of these risks before any subscription and must make sure that they have understood the present document. We recommend that all potential investors contact an advisor to determine whether this investment is suited to their profile.
The performance of a compartment is not guaranteed but can vary both upwards and downwards. The past performance of a compartment is not a reliable indicator of the future performance of the same compartment. Performance is quoted excluding the costs and commissions charged for subscription/redemption.
This document is not an investment recommendation. Similarly, this document does not constitute an offer of purchase or request to sell in countries where the compartments of the open-ended fund are not authorized to be traded or where any such offer or request would be illegal.
The commercial teams of Groupama Asset Management, the G FUND management company, are at your service if you wish a personal financial recommendation.
Published by Groupama Asset Management – Registered office: 25 rue de la ville l’Evêque, 75008 Paris – Website: www.groupama-am.com