Concern around high inflation and rising interest rates, compounded by the economic impact of the war in Ukraine, has had a negative effect on many credit markets this year. Spreads have widened more significantly in some parts of the market than others, particularly relative to how we perceive their fundamental credit quality and structure.
Although many fixed income markets are offering attractive opportunities, we think the corporate hybrid market stands out in particular. In our view, this is partly due to an overestimation of the corporate hybrid market’s exposure to the fallout from the war in Ukraine and the general growth slowdown, but mostly due to concern about the impact of rising rates—which we believe is rooted in some common misapprehensions about the structure of these securities.
Corporate hybrids are generally long-dated but callable subordinated securities issued by investment-grade, non-financial companies. Unlike bonds, their coupon payments can be deferred, much like equity dividends. Because of these equity-like features, the major credit rating agencies—including Standard & Poor’s (S&P) and Moody’s—typically treat them as half equity and half senior debt, which can make them an attractive option for issuers looking to optimize their weighted average cost of capital. For their part, investors have generally been compensated for hybrids’ features with a spread that is considerably wider, on average, than the same issuers’ senior bonds.
We can see that spread pick-up in figure 1. But we can also see how hybrid spreads have widened further than senior spreads during 2022. What is the cause, and should hybrid investors be concerned?
FIGURE 1. HYBRID SPREADS HAVE WIDENED MORE THAN SENIOR SPREADS SO FAR IN 2022
Source: Bloomberg, Neuberger Berman. Data as of March 31, 2022. Hybrid Spread is the market capitalization-weighted z-spread of a proprietary universe of securities, which, to the best of our knowledge, includes all non-financial corporate hybrid instruments, globally, across all ratings categories, sector and geographies. Senior Spread is the market capitalization-weighted z-spread of the senior bonds issued by the same issuers represented in the proprietary universe of corporate hybrid instruments. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
We think one cause is that investors are worried about rising interest rates. Many appear concerned that this could push yields on new senior bond issues up to the point where it is cheaper for borrowers to leave existing hybrids outstanding rather than raise new debt—so-called “extension risk”.
The average duration of the universe of global corporate hybrid securities that we follow, based on first call date, is around four years. Because a hybrid’s coupon will be higher than the same issuer’s senior bonds at the same maturity, it will also exhibit lower convexity, which is the rate at which its duration lengthens as rates go up. But if a hybrid is not called, it begins to look like a very long-duration, higher-convexity exposure. That’s not the kind of thing most investors want in a rising-rate environment.
There are good reasons why so few corporate hybrids have been extended beyond their first call date, however. A hybrid does not retain its original status or coupon in the event of an extension. Those rated by S&P typically lose their 50% equity treatment: they become straight senior debt when the agency crunches its numbers and assigns a credit rating to the issuer. And the coupons are re-set to a level equal to the hybrid’s initial credit spread at issuance, plus the five-year interest rate swap rate at the time of the re-set—plus, in some cases, an additional, punitive 25-basis-point “step-up”.
Therefore, in determining whether it is economically worth calling the bond, what matters to the issuer is how a hybrid security’s re-set spread compares with the spread of a new senior bond.
We can see that comparison in figure 2. The current average re-set spread of global corporate hybrids is 340 basis points. The average non-financial senior debt spread hasn’t hit anything like that level for decades—including during the heights of the Global Financial Crisis, Eurozone Crisis or COVID-19 pandemic. Even if an issuer is prepared to lose a hybrid’s S&P equity treatment, there is very little incentive to leave it outstanding, as it would effectively turn into a very expensive piece of senior debt.
FIGURE 1. SENIOR SPREADS NEED TO RISE A LOT MORE BEFORE THEY INCENTIVIZE EXTENSION OF A HYBRID
Average re-set spread for the current corporate hybrid universe versus average current and historical spread for euro non-financial senior debt
Source: Bloomberg, ICE Bank of America, Neuberger Berman. Data as of March 28, 2022. Euro Senior Non-Financial Spread is the asset swap spread of the ICE Bank of America Euro Non-Financial Index. Hybrid Re-set Spread is the estimated current market capitalization-weighted asset swap spread of a proprietary universe of hybrid securities that would result should their issuers choose not to call them at their first call date; to the best of our knowledge, this proprietary universe includes all non-financial corporate hybrid instruments, globally, across all ratings categories, sector and geographies. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
If extension risk does not justify the disproportionate sell-off in corporate hybrids, perhaps it is due to higher perceived credit risk, now that high inflation, tighter monetary policy, and the conflict in Ukraine have raised the prospect of a growth slowdown? After all, unlike with senior debt, hybrid issuers can strengthen their balance sheets by deferring coupon payments without falling into default.
Before we look into the incentives against deferring coupons, let’s consider whether the typical hybrid issuer is likely to be tempted to consider such an action in the first place.
We think that the companies best able to withstand the current environment of slowing growth and high inflation are those with real assets, regulated revenue streams (especially those that rise with an inflation index), and long histories of strong pricing power and consistent payment of rising dividends to shareholders. Notably, some 30% of hybrid issuers are utilities, 25% are basic materials or energy companies, 16% are in telecoms and another 6% are in real estate—sectors that feature many companies with one or more of those features. More broadly, most of the largest hybrid issuers are leaders in their sectors, with significant pricing power and decades-long histories of successful operation through economic cycles and exogenous crises. Hybrid issuers are typically rated BBB+ or higher.
We particularly favor renewables developers and power network companies. We believe renewables developers will enjoy better pricing terms and lock in more attractive returns on capital in new projects due to rising global gas and power prices, while benefitting from policy initiatives that support a higher pace of capital deployment. Power network assets typically have inflation and interest rates embedded in their cost-of-capital calculations, which in turn determines the underlying earnings power of their assets.
But let’s assume that one of these very robust hybrid issuers gets into some financial difficulty. Would it then be likely to defer a coupon payment?
We think not. Hybrids come with embedded “Dividend Pusher” and “Dividend Stopper” mechanisms that tie their coupon payments to shareholder dividend payments. Under these mechanisms, should a hybrid coupon be deferred, the issuer cannot pay dividends or otherwise return capital to shareholders—and, as we noted already, many hybrid issuers are recognized and valued by the equity market as consistent payers of high dividends.
Should an issuer defer multiple coupons, they would accumulate and, when they are finally repaid, they are likely also to have accrued additional interest on that unpaid interest. Even if a hybrid issuer gets into enough difficulty to need to cut its dividend to zero, therefore, suspending its hybrid coupons would still be a drastic step, as it would make it more difficult and potentially more expensive to reinstate those dividends in better times. It’s the kind of measure one would anticipate only from a company facing a weak and deteriorating liquidity position—and we think that is why, to the best of our knowledge, no investment-grade issuer has ever missed a hybrid coupon payment.
Credit markets have endured a sell-off over recent weeks, and corporate hybrid securities appear to have sold off particularly heavily, compared with other fixed income sectors.
When we look for reasons, we come up against the usual suspects: concern that rising rates might incentivize extensions, and concern that an economic slowdown might incentivize coupon deferrals. We believe both concerns are significantly overstated, particularly for hybrid investors focused on investment-grade, high-quality issuers.
We therefore conclude that the global corporate hybrids market, which is typically attractively valued relative to equivalent senior debt, is particularly attractively valued today.