Today’s CIO Weekly Perspectives comes from guest contributor Julian Marks.
Few investors know much about Europe’s market in corporate hybrid securities, but everyone has heard of Vodafone. A few weeks ago, this household name in telecommunications, one of the U.K.’s largest companies, raised the equivalent of €4 billion by issuing its first hybrid. A couple of years earlier, the firm’s treasurer had indicated a reluctance to tap this market.
Vodafone’s hybrid is another sign of how fast this market is maturing. From virtually nothing a decade ago, there is now close to $200 billion worth of hybrids outstanding, most of it from large, investment-grade companies like Vodafone.
So what changed this one corporate treasurer’s mind? And why might you, an investor searching for yield in a maturing credit cycle, want to know about this little-covered corner of the market?
Lower Cost of Capital
Corporate hybrids are, as the name suggests, a hybrid of equity- and bond-like capital.
They are either extremely long-dated or perpetual, and while they pay coupons, like bonds, issuers can stop paying those coupons without defaulting, as long as they also stop paying dividends to shareholders.
These equity-like features mean rating agencies recognize them as a contribution to a company’s equity capital. That is useful for issuers: hybrids are cheaper to issue than equity and their coupons are tax deductible, so they impose a lower cost of capital than an equivalent mix of straight equity and senior debt.
Despite these useful equity-like features, however, issuers almost always call hybrids back as soon as they can—generally after five years—because if they leave them outstanding, coupon payments increase substantially, the rating agencies’ equity credit is stripped away and relations with the capital markets are severely damaged. To investors, that makes a hybrid look very much like a bond.
The bond-like characteristics were what used to put Vodafone off. As its treasurer pointed out, a company like Vodafone could never stop paying dividends and could never afford to alienate the capital markets. That rules out deferring hybrid coupon payments or extending this cheap financing beyond its first call date. What’s the use of options that you’ll never be able to exercise?
Earlier this year, however, Vodafone agreed to buy €18 billion worth of cable television and broadband assets in Germany and eastern Europe. Suddenly, the attractiveness of issuing hybrids that substantially reduce Vodafone’s cost of capital seemingly outweighed the fact that it was never likely to exercise the options. It’s a calculation that scores of similar issuers—firms such as Bayer, Vattenfall, Ørsted, Engie, Telefonica and Repsol—have made over the past 10 years.
That list of issuers hints at why hybrids might be especially attractive when credit spreads are tight and we are moving into the mature part of the credit cycle.
Until the hybrids market developed, fixed income investors seeking more spread for their portfolios had little choice than to edge gingerly down the credit spectrum to lower-rated issuers. With hybrids, investors can instead stay with higher-rated issuers and get more spread by moving down the capital structure.
The average corporate hybrid is rated BBB or BBB-, but the issuers, the likes of the companies named above, are typically rated two or three notches higher. Few have ever missed a dividend, let alone a coupon payment. Buying their subordinated securities rather than similarly rated senior bonds from other issuers is a trade-off: accepting the risk of a bigger loss should an issuer default because the issuer presents a lower probability of default.
In other words, should default rates begin to rise, hybrids could prove a less risky way of getting extra spread than buying higher-yielding senior bonds. Now that Vodafone has got wise to their potential, maybe it’s time for fixed income investors to get wise, too?
In Case You Missed It
- NAHB Housing Market Index: -8 to 60 in November
- U.S. Building Starts: -0.6% to SAAR of 1.26 million units in October
- U.S. Housing Permits: +1.5% to SAAR of 1.23 million units in October
- U.S. Durable Goods Orders: -4.4% in October (excluding transportation, durable goods orders increased 0.2%)
What to Watch For
- Tuesday, 11/27:
- S&P Case-Shiller Home Prices Index
- U.S. Consumer Confidence
- Wednesday, 11/28:
- U.S. Q32018 GDP (Second Estimate)
- U.S. New Home Sales
- Thursday, 11/29:
- U.S. Personal Income & Outlays
- FOMC Minutes
Statistics on the Current State of the Market – as of November 23, 2018
|S&P 500 Index||-3.8%||-2.7%||0.2%|
|Russell 1000 Index||-3.6%||-2.7%||-0.1%|
|Russell 1000 Growth Index||-4.6%||-4.7%||1.6%|
|Russell 1000 Value Index||-2.7%||-0.6%||-2.1%|
|Russell 2000 Index||-2.5%||-1.4%||-2.0%|
|MSCI World Index||-2.8%||-2.1%||-4.0%|
|MSCI EAFE Index||-1.1%||-1.1%||-9.8%|
|MSCI Emerging Markets Index||-1.7%||1.4%||-14.2%|
|STOXX Europe 600||-1.4%||-1.9%||-11.7%|
|FTSE 100 Index||-0.7%||-2.0%||-5.8%|
|CSI 300 Index||-3.5%||-0.3%||-20.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.3%||0.6%|
|Citigroup 10-Year Treasury Index||0.2%||1.0%||-3.4%|
|Bloomberg Barclays Municipal Bond Index||0.2%||0.6%||-0.5%|
|Bloomberg Barclays US Aggregate Bond Index||0.0%||0.5%||-1.9%|
|Bloomberg Barclays Global Aggregate Index||-0.1%||0.3%||-3.1%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.5%||-0.7%||3.0%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.3%||-1.3%||-0.5%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.4%||-1.2%||-2.4%|
|JP Morgan EMBI Global Diversified Index||-0.7%||-0.9%||-6.0%|
|JP Morgan GBI-EM Global Diversified Index||0.0%||2.6%||-7.6%|
|U.S. Dollar per British Pounds||-0.3%||0.2%||-5.3%|
|U.S. Dollar per Euro||-0.4%||0.1%||-5.5%|
|U.S. Dollar per Japanese Yen||0.1%||0.1%||-0.1%|
|Real & Alternative Assets|
|Alerian MLP Index||-3.2%||-2.3%||-4.8%|
|FTSE EPRA/NAREIT North America Index||-0.7%||2.2%||2.2%|
|FTSE EPRA/NAREIT Global Index||-0.4%||2.7%||-2.2%|
|Bloomberg Commodity Index||-2.9%||-1.9%||-6.0%|
|Gold (NYM $/ozt) Continuous Future||0.0%||0.7%||-6.6%|
|Crude Oil (NYM $/bbl) Continuous Future||-11.0%||-22.8%||-16.6%|
Source: FactSet, Neuberger Berman.