Whisper it quietly but the European industrial is fighting back. It’s a story of rags to riches where a once unloved corner of the bond market is growing from strength to strength.
Witness the remarkable rise of the European Hybrid market. 2013 alone has seen this unique asset class double in size compared to the amount issued in the prior 10 years (that’s Eur21bn YTD and counting).
What is a hybrid? Hybrids take their name from the fact that they have bond like characteristics but the kicker is that the ratings agencies give companies that issue them equity credit as well. They do this because while a hybrid pays coupon and has a series of call dates (like many bonds), they are also deeply subordinated to senior bond holders, carry the risk of coupon deferral and their final maturities are either very long dated or perpetual.
Why are industrial companies issuing them? Quite simply it bolsters their balance sheets, providing support to the senior unsecured ratings of the company and taps into a new source of cash that was previously unavailable… and all for a lower cost than issuing actual equity (especially as the coupon payments are tax deductable).
Why are investors interested? For starters despite the health warnings listed above most of the issuance is in fact investment grade and forms a legitimate and growing component of benchmarks. Their yields are also far in excess of what senior bonds are paying. Investors who buy hybrids are certainly looking for market beta and yield but it also follows the theory of buying the highest yielding obligation of a sound company. Indeed, much of the issuance has been from the utility sector where business risk is comparatively low. In this instance investors can earn 2-3 times the amount of spread by purchasing the hybrid over the senior bond.
How do you decide which hybrids to buy? Now comes the tricky part where the devil is in the detail and you cannot stress enough the importance of strong credit analysis. Above all else, purchasing a hybrid is a call on the fundamental health of a company. A sufficiently deteriorating credit profile will mean deferred coupons and given the deep subordination little if any recovery in the event a company eventually defaults. These aren’t risks to be taken lightly. Secondly, the evolving nature of the asset class means it has grown in an uneven fashion. The current incarnation was preceded with earlier iterations that gave rise to bonds that had very different call and reset structures and varying incentives to act in the interest on the bond holder. Mastering the terms and conditions of each bond is thus vital.
Has high supply weighed on the market? Absolutely not. The technical aspect of the market is extremely strong. A recent new issue Telefonica hybrid (which was rated below investment grade) received orders that were over 8 x the amount being issued by the company.
How do you value a hybrid? Ok so perhaps this question is just for the bond geeks among us. What’s important to highlight at this stage is that hybrids have an initial call date that usually ranges from 5-10 years… after which S&P will remove their equity support and the coupon will reset to reflect the prevailing interest rate regime. At issuance bonds price to this call date, meaning everyone that buys them expects in good faith that the company will redeem them at the first opportunity. What if this didn’t happen? Well a bond that was pricing to a 5 year maturity would suddenly be valued as either very long dated or perpetual. What’s more it could signify deeper issues with the company and the price of the hybrid would drop like a stone. In a nutshell, valuation principally rests on the perceived probability that the issuer will call the bond.
What happens next? Supply and lots more of it.