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#Investments — 07.08.2017

10 Questions To Understand Corporate Hybrid Bonds

Thierry Trigo

In sectors where heavy investment spending (Capex) is necessary (Utilities, Telecoms), corporate hybrid bonds serve to finance long-term investments, without deteriorating the issuer’s financial profile. Today, hybrids are mainly used for refinancing purposes by issuers who wish to stabilise their financial profile and prevent a rating downgrade. In this way, a positive message is sent to credit rating agencies and to holders of senior debt of the issuers in question.

1. What are corporate hybrids?

Corporate hybrid bonds are subordinated debt instruments issued by non-financial companies ‘Corporates’.  They are known as ‘hybrids’ because they combine characteristics of bonds (payment of a coupon) and of equities (no maturity date or very long maturities; the issuer may decide not to pay the coupon, as is the case for dividends).

Rating agencies regard corporate hybrids as half-debt and half-capital, applying the concept of ‘equity content’, which tends to improve the issuer’s credit ratios.

2. What are the characteristics of the corporate hybrid market?

  • This is a young market, created in 2005, which has seen strong growth since 2013, subsequently increasing five-fold. In 2016, the total value of this market stood at €101bn, up from €20bn in 2013.
  • There is a limited number of hybrids available: only around 100 (90% of them denominated in euros), issued by some 50 companies – mainly from the Utilities and Telecoms sectors, although the market has been gradually extending to other sectors.
  • This is a fairly liquid market: issues are often of  benchmark size, i.e. €500 million or above, with prices quoted within a fairly tight bid/ask range.

3. Are all issuers of Corporate hybrids rated?

No. The market has gradually opened up to companies with sufficiently high profiles and reputations to issue hybrids, such as Air France/KLM, Aryzta, Bourbon, Eurofins, VTG, Finnair, Outotec and Voestalpine. Investors have quickly come to appreciate the extra yield provided by hybrids to offset the absence of an official rating and regular information.

4. What are the advantages for the investor?

Hybrid issuers often have a high-quality financial profile as they are globally Investment Grade rated. This marks a considerable difference from the High Yield Euro market, where issuers frequently have a significantly less robust financial profile. Hybrids are generally issued by companies that generate solid, consistent operating cash flow.

Hybrids offer an attractive yield
:  these bonds are high-yielding because they are subordinated debt instruments whose rating is on average 2-3 notches lower than the same issuers’ senior debt. There are other risks associated with this type of instrument which also justify a higher yield.

Euro-denominated hybrids with a first call date of 5 years today provide an average yield close to 3%, compared with a yield of around 0.50% for 5-year senior debt issued by the same borrower. So there is a considerable yield advantage here. The same goes for the related risks.  To obtain the same yield over the same period, an investor today would have to take the risk of purchasing a High Yield B-rated bond. So hybrids offer an attractive risk/yield ratio. Moreover, incidents associated with hybrids are rare.

5. What are the risks associated with holding corporate hybrid bonds?

  • Credit risk: this is a vital factor. This risk is quite small as regards issuers who are improving their financial profile on a regular basis and, since the paper of hybrid issuers is normally rated Investment Grade, their rating is not very volatile.
  • Interest rate risk: hybrids whose first call date is still a long way off are more sensitive to interest rate fluctuations.
  • Subordination risk: Should the issuer default, the rate of recovery for the holders of hybrid securities is usually quite low as senior debt holders take priority (first in line after payment of salaries, taxes and any secured debt that may exist). However, defaults by issuers with Investment Grade ratings are extremely rare.   
  • Extension risk: if the hybrid is not called at the first call date, the valuation of the security may fall by some 10%. Such cases have already occurred.
  • Deferral of the coupon payment: this risk is very low during periods of economic growth but such things may happen if the issuer gets into serious difficulties. This may have serious consequences for the issuer’s ability to tap the bond market in future as the company’s reputation will often be tarnished by this kind of event.
  • Risk of a call at 101% of par: This may happen if specific clauses in the issue prospectus are triggered by certain events (such as for example if a ratings agency changes its rating methodology). This risk has become rarer than it was two years ago but prudence leads us to recommend buying hybrids whose price is lower than 101%.
  • Volatility risk: Corporate hybrids are positively correlated to the equity markets. During periods of risk aversion, share prices fall and the credit spread on hybrids widens, as yields rise and hybrid prices fall.

6. Although hybrid bonds are ‘perpetual’ (‘perps’) – or of very long maturity, is there any possibility of recovering the invested capital without selling the bond?

Yes, there is a call date, 5 or 10 years after the issue date. Whenever the issuer exercises the call, the investor will be entirely reimbursed, at a price of 100%. It is a market convention that corporate hybrids are normally redeemed at the first call date. It is rare for the issuer not to exercise the call.

7. Is there any guarantee that the coupon will be paid?

No. As a hybrid security is classed as subordinated debt, with quasi-equity characteristics, payment of the coupon is at the discretion of the issuer, and he is entitled not to pay the coupon without this decision triggering a declaration of default.

However, opting not to pay a coupon is a serious matter which will have a negative impact on the issuer’s reputation and restrict his ability to refinance, not only via hybrid instruments but also via senior debt. This decision is usually taken only in cases where the issuer is experiencing serious difficulties. Hence the importance of always being able to follow the evolution of the issuer’s financial profile on a regular basis. There is a higher risk that a coupon will not be paid where the issuer is a non-rated issuer.

Lastly, the issuer may decide not to pay the coupon on a hybrid bond if no dividend on the company’s equity has been distributed.  Coupons are said to be ‘cumulative’. This means that unpaid coupons will be settled in full as soon as the issuer is once again in a position to distribute dividends on the company equity.

8. How will the price of a hybrid security be affected if it should happen that a call is not exercised and the coupon not paid?

A financial instrument without maturity date (a ‘perpetual’ or ‘perp’), which is no longer paying its coupons, is not worth much. It can easily lose 60% of its value and become illiquid. Nevertheless, the issuer may well not be in a default situation and measures might yet be taken, such as selling off part of the business, suspending the dividend, reducing Capex, undertaking a capital increase, bringing in a new shareholder, obtaining support from the banks, etc., so as to gradually improve cash flow generation. Consequently there is often greater hope of improvement in the situation compared with cases where a High Yield issuer declares default.

9. What are the main factors affecting the price of a hybrid security?

Corporate hybrids are positively correlated to the equity markets, i.e. when share prices rise the price of corporate hybrids will also rise. The way this works is that share prices most often rise when market players are expecting an improvement in economic growth. This favourable macro-economic situation also helps to improve the financial profile of issuers. So their ratings improve, credit spreads narrow and consequently the market price of hybrids rises. Conversely, a fall in the stock markets will also weigh upon the value of hybrid securities.

It should be noted that during periods of economic growth, the benchmark rates (long-dated German bonds or ‘Bunds’) often trend upwards, which should negatively impact the valuations on corporate hybrids.
However, this is rarely the case because the narrowing of the credit spreads is often more pronounced than the rise in the benchmark yield. The credit spread is in fact the most significant component of the yield on a hybrid.

Take for example the EnBw 3.375% 2077 call 04/2022. This hybrid offers a yield-to-call of 2.23%, which may be split into two parts: the benchmark yield (German sovereign 5-year debt), currently at -0.25%, plus a credit spread of 248bps (as at 25/07/17). This rather significant (for an Investment Grade-rated hybrid) credit spread holds potential for a reduction should rates rise.

Meanwhile variations in the probability of a non-call also create volatility. On the other hand, everything becomes more complicated and more risky for hybrids during periods of economic slowdown and – even worse – during a recession.

10. What are the special characteristics of non-rated issuers of corporate hybrids?

  • Issuers who already have a number of hybrids in circulation
  • Hybrids rated by S&P (as regards the removal of the ‘equity content’ after the first call date)
  • First call date not too far away (7 years max for euro-denominated bonds)
  • Issuers who take account of their reputation
  • Issuers with a stable – or improving – financial profile
  • Issuers regarded as major players in the Investment Grade market who are also making profits  (and are thus more likely to pay dividends on their equity)
  • Hybrids whose price is not too far above 101%.
  • Our primary aim is to enable our clients to obtain high coupons on a regular basis until the first call date, with the priority on hybrids that are not too volatile.