It has been a volatile few months for most asset classes, and corporate hybrid bonds have been no exception. At the start of November, the ICE Global Non-Financial Hybrid 5% Constrained Custom Index (Total Return, Euro Hedged) traded with a yield of 2.85% and a spread of 241 basis points; by year-end that had moved to 3.22% and 289 basis points; and a month later it was back to 2.88% and 257 basis points.
That was quite a ride. Along with the general volatility in risk assets, there were a few specific additional factors that affected corporate hybrids.
The most important of those factors were the end of the European Central Bank’s (ECB) corporate-bond purchasing program in December, market anticipation of the ECB’s move from negative back to positive policy rates later this year, and widening Eurozone senior bond spreads.
Concerns around all three contributed to wider hybrid spreads in the closing weeks of 2018. But we would argue that these market dynamics have also demonstrated the underlying robustness of this relatively new asset class, against the expectations of many skeptics.
Suppression of Senior Bond Yields
Corporate hybrids are long-dated but callable subordinated securities issued by investment-grade companies. Unlike normal bonds, their coupon payments can be deferred, much like equity dividends.
Because of these equity-like features, right up until their first call date the credit rating agency Standard & Poor’s treats them as half equity and half senior debt, which makes them an attractive option for issuers looking to optimize their weighted average cost of capital. Over recent years, as the market has grown, investors generally have been compensated for the equity-like risks with a spread four or five times wider, on average, than the same issuer’s senior bonds.
However, skeptics have ascribed at least some of that spread multiple to the suppression of senior bond yields due to the ECB’s quantitative easing program: non-financial, investment grade euro-denominated senior debt has been a prime candidate for purchase since the program started in March 2016.
The ECB has now stopped making net new purchases and is only re-investing coupons. Sure enough, senior spreads have widened to a level that we believe is close to fair value. But so have the spreads of hybrids, which were never on the ECB’s buy list. Hybrids still trade with an average spread four times wider than senior debt—despite what we regard as a fair-value level of around two or two-and-a-half times.
Figure 1. Senior spreads have risen, but so have hybrid spreads
Source: Bloomberg. The chart shows the average credit spread of a representative universe of corporate hybrid securities, together with the average credit spread of the senior bonds from the same issuers.
Our View: “No Call for Concern”
Another common concern has been that the prospect of tighter monetary policy, and specifically higher interest rates, could push up hybrid yields. Leaving aside the question of whether the ECB will hike rates, we believe the concern is misplaced.
It arises because higher rates are often mistaken for an incentive not to call hybrids. Hybrid securities are generally callable after five to eight years and they tend to trade to their first call date in the secondary market. If the market expected them not to be called, yields and spreads would seemingly be commensurately higher.
Leaving a fixed-coupon security outstanding would appear to be advantageous to an issuer in a rising-rate environment. Hybrids are not like other fixed-coupon instruments, however. Crucially, if they are not called, their coupons are re-set and Standard & Poor’s rescinds their 50%-equity treatment.
Were a hybrid left outstanding, its coupons are re-set from their original fixed rate to a new fixed rate, based on the original fixed rate plus the currently prevailing five-year swap rate (for reference, the average original hybrid premium spread has been 370 basis points, compared with today’s spread of 100 basis points for senior bonds). There is often an additional 25 basis point penalty step-up, too. And that whole process is repeated again five years later, with the hybrid moving to a floating rate above its original spread. Leaving a hybrid outstanding does not really lock-in a very long-dated fixed rate, then.
Moreover, it is important to appreciate that an issuer does not assess the case for calling a hybrid based on its yield in isolation, but rather based on its yield relative to the yield it would have to pay to issue senior debt. Once a hybrid’s equity treatment is rescinded, it is essentially just another form of senior debt, with its coupon determined by the issuer’s hybrid credit spread when the security was first issued, and the prevailing five-year swap rate.
What determines the yield on senior debt? The issuer’s senior credit spread over the prevailing swap rate. Therefore, leaving a hybrid outstanding offers no advantage over calling it and refinancing it as senior debt unless the original yield of the hybrid was priced lower than the current yield of the issuer’s senior debt. For reference, non-financial euro-denominated senior spreads have never come close to the level that hybrids tend to be set at, even during the Eurozone crisis.
In short, senior debt will almost certainly be sellable at a lower yield, and it may even be sellable at a longer effective maturity. The apparent incentives not to call and refinance a hybrid as senior turn out to be illusory.
Given the recent decision by Banco Santander not to call one of its additional tier 1 capital bonds, or “CoCos”, it is worth noting how different the incentives are in that market: at current market levels leaving CoCos outstanding may be economically advantageous to the issuer, partly because they do not have coupon step-ups; they do not lose their equity content at their first call date; and even when an issuer would prefer to call a CoCo, its regulator can prevent it from doing so if it is concerned about the bank’s capital ratio.
If anything, the news out of Santander serves to underline the incentives that hybrid issuers have to call their bonds. That is why we—and the wider market—would expect them to be called in the absence of exceptionally severe idiosyncratic credit deterioration, or a systemic crisis of even greater magnitude than that of 2008.
Structural Yield Pick-Up
To the extent that hybrid security spreads have widened due to concerns about call probability as interest rates begin to rise—and we believe this has indeed been a factor recently—we would argue that represents part of the current value opportunity in the asset class.
The recent volatility in credit and risk assets in general has provided hybrids with one of their first big tests since the market started to grow substantially, six years ago. Overall, they have passed that test comfortably, responding to current dynamics as we would have expected and consolidating their reputation as a source of structural yield pick-up relative to their issuers’ senior bonds.
