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Hybrids gain traction within the credit universe

14 May 2013

In recent months many observers have dismissed the ability of European credit markets to continue to offer attractive investment opportunities, arguing that tightening spreads and rampant equity markets are likely to prompt investors to seek returns elsewhere. In reality, this ‘Great Rotation’ is proving something of a mirage, with capital flows data suggesting European investors continue to raise, not lower, their exposure to bond markets. While credit valuations are becoming more stretched in some areas, it seems that the low-growth environment means that the search for yield in fixed income markets is set to continue.

One area that is flourishing in the present environment is the corporate hybrid debt market – these are bonds which have some equity like characteristics. Issuance levels for hybrids have spiked in the first quarter of the year, reaching nearly €15 billion, compared to full year issuance of around €5 billion and €3 billion in 2012 and 2011 respectively. This resurgence can partly be explained by the role of low interest rates, enticing corporates to lock in current funding levels. However, there are other considerations that are prompting companies to pursue the hybrid route.

Perhaps most noticeably is the impact that these securities have on a company’s overall credit profile. Ratings agencies typically give hybrid bonds a 50% equity weighting. This limits the credit impact on such fundraisings - an important consideration for companies whose credit metrics are under pressure or are in danger of being downgraded. Secondly, while issuing a hybrid instrument is more expensive than issuing senior debt, it is less costly than a dilutive equity offering. This is particularly the case for those companies that do not have a compelling story for shareholders, for example, where earnings visibility is poor or when access to equity markets is limited - such as state-owned companies. Finally, hybrid instruments are tax efficient instruments as coupon payments are tax deductable.

So the rationale for issuers is fairly evident. However, what about investors? Does the renaissance of the hybrid debt market provide European credit investors with a relatively untapped yield opportunity? Possibly, although the risks associated with hybrid instruments are, by definition, higher than with other debt instruments, meaning investor discretion is required.

First, let us consider the risks inherent in hybrid debt instruments and how they compare to traditional senior bonds. The first point to note is that hybrid debt ranks below all other debt obligations in terms of a company’s capital structure. This is an important consideration, particularly in light of our earlier observation that companies tapping this market often have less earnings visibility and potentially a less comfortable relationship with equity markets.

This was certainly apparent for German utility firm RWE. The company has been negatively impacted by the German government’s decision to phase out nuclear energy production and by uncertainty about future energy prices on profitability. This may prove an unattractive prospect for equity investors; indeed, our colleagues in the European equity team have a ‘sell’ rating on the stock. However, while there are clearly headwinds to the business our detailed credit analysis suggests that the overall risks to the business are less severe than currently anticipated by markets. The company has strong electricity and gas positions in core European markets, a diversified generation portfolio and steady cashflows from its regulated assets, especially the domestic distribution grid business. These attributes makes investing in RWE’s hybrid debt, which yields approximately 4.4% at the time of writing, an attractive option for credit investors. Of course, not all hybrid issuers have redeeming features such as RWE. We would argue that the competitive and regulatory pressures facing Telecom Italia, for example, mean that even the approximate 7% yield to call available on its outstanding hybrid paper is insufficient to compensate investors for the challenges the company faces.

There is other risk considerations too. For example, does the structure of the instrument present additional risks and is the issuer adequately compensating for these? It is important to point out that not all hybrid structures are created equal. Corporates have considerable flexibility regarding the calling and resetting of coupon payments. For example, a company can remain a going concern but defer coupon payments on hybrids - while it must pay coupons on senior debt. Sometimes this is discretionary, for some hybrid's the coupon can be deferred if dividends are stopped, while in other circumstances it is mandatory if the company breaches certain debt covenants. These structural considerations add to the need for careful analysis, even if coupon deferral and extension risks are currently low.

Investors are right to pay close attention to the risks associated with hybrid debt, Clearly, a thorough understanding of corporate fundamentals is essential before investing in these instruments, hence our preference for names with robust balance sheets such as Electricite de France (EDF). However, we believe that there will continue to be selective opportunities to gain exposure to companies in this market at attractive pricing levels.

The recent surge in issuance has added momentum, liquidity and a greater choice for hybrid investors. It has also highlighted that, while demand for credit has been sustained for longer than some observers predicted, there are few signs that the story has come to a conclusion. Indeed, with the low yield environment set to remain for a while, we may see new participants switching out of government bonds and seeking income through credit markets.

Source: Yields from Bloomberg as at May 10, 2013

David Sol, Investment Director, Corporate Bonds

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.