The recent growth of the corporate hybrid market has been significant and is increasingly sparking the attention of both investors and issuers, writes Julian Marks.
The non-financial corporate hybrid market was a niche $20bn credit segment little over five years ago, but today the burgeoning $180bn market plays an important role in enhancing investor performance in the current low-yield environment.
These subordinated instruments sit below senior bonds in the capital structure, are long-dated but callable and have deferrable coupons. To compensate for these features, corporate hybrid debt yields are significantly higher than senior bonds of the same well-known investment grade issuers.
However, investors should not confuse non-financial corporate hybrids with the banking world’s contingent convertible capital notes, commonly known as ‘CoCos’. While CoCos have generated much more attention in the press, in our view the quieter corporate hybrids offer the more compelling risk/reward relationship. Corporate hybrids are unambiguously debt, whereas CoCos can genuinely end up as equity or be written down, while the company is still a going concern. Issuers’ managers alone decide how to use the coupon flexibility afforded by corporate hybrids – they have strong incentives to pay the coupons and hence there has never been a coupon miss by a rated corporate hybrid issue – while payment of Coco coupons needs to be approved by regulators.
Below are the three factors likely to drive the corporate hybrid market forward for the remainder of 2018:
Spreads unjustifiably wide for high-quality hybrids
Considering the majority of the corporate hybrid market consists of globally-recognised, high-quality investment grade names – the average rating of the issuers in our portfolio is low single-A – the asset class offers a compelling yield of 2.77%*. This compares favourably to the 2.18% offered by the BB-rated Euro High Yield index, while it also offers a far superior risk/reward than the CoCo index’s yield of 2.83%.
The corporate hybrid market is trading about 75bp wide of fair value and we would expect some spread compression over the remainder of 2018. Investors can currently achieve roughly four times the spread by moving from seniors to corporate hybrids, but we believe the spread differential – when taking into account the different structures of the bonds – should be no more than two times.
Hybrid issuance to accelerate on M&A revival
Corporates issue hybrids for multiple reasons, including bolstering capital levels, lowering the weighted average cost of capital, diversifying funding sources and managing credit ratings. Hybrid capital is significantly cheaper to issue than common equity, while preventing ownership dilution. Many high-quality companies have been attracted to the hybrid structure. For example, our top holdings include the likes of Volkswagen, National Grid, Total and Orange.
Another key catalyst for issuance recently has been M&A activity. Together with refinancing, we expect M&A to remain a key driver of corporate hybrid issuance as the European recovery continues. For example, commercial property company Unibail-Rodamco came to market in April in a widely-anticipated hybrid deal to help fund its acquisition of Westfield. The company priced €1.25bn of a 5.5 years-to-call deal and €750m of an 8 years-to-call at 2.125% and 2.875% respectively. We also expect Vodafone to issue $4-8bn of hybrid capital to finance its Liberty acquisition. Encouragingly, we have seen a large proportion of new issuance come at a discount to fair value.
Brexit fears impacting the robust UK utilities
Unsurprisingly, due to the continued uncertainty surrounding the UK’s exit from the European Union, global investors are largely ignoring UK assets. We believe UK utilities – such as National Grid, Centrica and SSE – are trading at unjustifiably wide spreads on a mistaken belief that Brexit is likely to cause serious damage to these businesses, which will continue to benefit from strong, regulated cashflow, even in the event of a deep UK recession.
While there continues to be numerous economic and political uncertainties in the UK due to the ever-shifting Brexit negotiations, the fundamentals of UK utility companies are strong and the industry’s exposure to broader economic performance is limited. We believe investors will shortly recognise this space has been oversold.
Julian Marks is manager of the Neuberger Berman Corporate Hybrid Bond Fund