by Julian Marks, CFA, Senior Portfolio Manager, Neuberger Berman
We believe the nearly €200 billion corporate hybrid market just got its first true test—and passed with flying colors.
Although the first non-financial corporate hybrid securities were issued nearly 20 years ago, the market really started to grow only in 2013. Before that, it amounted to no more than a few billion euros. We believe that makes the coronavirus crisis the first true test of this now substantial market.
How has it fared?
We would argue that 2020 will turn out to be a milestone year for the asset class—for all the right reasons.
Following the pause in new issuance across credit markets in March and April, hybrids have come surging back.
We look set to achieve potential record gross new issuance in 2020, and have already seen the biggest net issuance since 2015. That includes the biggest ever hybrid deal, in June of this year: the equivalent of 12 billion in dollars, euros and sterling from the energy giant and first-time issuer, BP.
By the end of this year, we expect the market to top €200 billion for the first time, which would make it comparable in size to the market in banks’ contingent capital (“CoCos”) and almost half as big as the entire European high yield bond market.
Less Downside Risk
That vote of confidence from issuers and investors consolidates a period during which the market functioned and priced just as we would have expected, despite extreme volatility and dislocation across the fixed income universe.
On average, hybrid issuers are rated investment grade (BBB+), as are the securities themselves (BBB-). That supports our view that hybrids generally present less downside risk than high yield bonds, which is what we saw in March. The option-adjusted spread on the ICE Bank of America Global Hybrid Corporate Index hit a high of 389 basis points, compared with 1,094 basis points for the Global High Yield Index and 673 basis points for the Euro High Yield BB Index. The Euro Corporate BBB Index, which represents the senior bonds of issuers similar to hybrid issuers, reached a spread of 286 basis points.
Corporate hybrids are often likened to CoCos, and so it was reassuring to see them outperform this asset class during the sell-off in March: The ICE Bank of America Contingent Capital Index reached an option-adjusted spread of 694 basis points.
This makes sense to us, too.
Corporate hybrids, while usually perpetual, tend to trade as if they will be called at their first call date. Issuers can stop paying coupons without defaulting as long as they also stop paying dividends, but we have not seen this ever happen. They can also choose not to call them, but this has very rarely happened. That’s because, if an issuer fails to call a hybrid, it not only undergoes a substantial step-up in coupons, but certain rating agencies could also stop counting it as a contribution to the issuer’s equity. The incentives to pay the coupons and call the bond at the first call date are, in our view, strong.
By contrast, banks can be compelled to convert their CoCos to equity and/or be prevented from paying coupons on CoCos by regulators. For this reason, we have always argued that the comparison of CoCos with corporate hybrid bonds is misleading. This year’s price action suggests to us that the market agrees.
Will the coronavirus fallout change the incentives?
It is true that BP issued hybrids mainly to strengthen its balance sheet following a major write-down due to lower energy price forecasts—hybrid capital may help protect a credit rating by providing the issuer some “equity content” from rating agencies without diluting shareholders.
But that is not the only reason we have seen for hybrid issuance this year. Others have come for cheap, efficient refinancing and some have issued them to fund acquisitions.
Moreover, issuers have been using hybrids to protect ratings for a long time, but that has not translated into missed coupons or extensions beyond a first call date on any outstanding hybrids this year. That remains the case even though many companies have been cutting and even suspending dividends, thereby removing one of the obstacles to skipping hybrid coupons.
It is possible that some issuers might take advantage of the costly optionality that hybrids give them—the travel, leisure, airline and hotel sectors have been struggling, after all. But they are a tiny proportion of the hybrid universe, which is still dominated by utilities, telecoms and large energy companies. The issuers from the struggling sectors are also either unrated or rated high yield at the senior level, and, given the typical spread that hybrids offer over an issuer’s senior bonds, we have never considered it necessary to invest in high yield companies. Today, the average hybrid spread is close to three times as wide as the average European BBB senior spread.
At Neuberger Berman, we believe in the potential of the corporate hybrid asset class and have waited a long time to see its resilience in a genuinely testing environment. This year provided as stiff a test as we could have imagined.
In our view, corporate hybrids not only passed with flying colors, but still offer yield-seeking investors notably attractive credit spread opportunities relative to the high quality of their issuers.