If it looks like a duck
Hybrid corporate bonds are taking off as investors scramble for yield. But Martin Steward wonders if the hybdridity balance is shifting against investors
Hybrid securities are a very handy source of funding for corporate CFOs. With their bond-like coupons but equity-like characteristics (they are either very long dated or perpetual, and coupons can be suspended), they are especially handy if you are in a spot of bother and the rating agencies are on your back.
One simple way of defending the rating on your senior bonds is to issue more equity – but that can be very expensive capital. But rating agencies can treat 50% of a hybrid issue as equity capital when considering debt ratios, while investors will demand less return because it is senior to ‘real’ equity. The CFO of Dutch telecoms firm KPN has admitted that his twin €4bn equity, €2bn hybrid capital-raise was all about avoiding a de-rating to junk.
But sometimes this attempt to persuade rating agencies that something is equity and investors that is is debt fails to add up. KPN’s hybrids slumped when it stopped its dividends recently, because that is a pre-requisite for deferring coupons. Investors were reminded why the agencies give them some ‘equity content’.
And yet Dealogic figures suggest that the market has doubled in size with this year’s €20bn worth of issuance, as the traditional utilities have been joined by other sectors.
“This is something we see spreading because people are desperate for yield rather than because it is a great thing to own,” says Wolfgang Kuhn, head of pan-European fixed income at Aberdeen Asset Management. “The term ‘a little bit of extra yield’ is problematic – you are often taking a lot of extra risk. I fear that a lot of investors are underestimating the risk, just as they did in 2006-07.”
There is no doubt that some buyers are getting involved simply because these riskier securities have started to sway the benchmarks – but others see genuine opportunity.
“Hybrids are a big theme for us,” says SWIP’s credit investment director Mark Munro, for example. “But we are very mindful of getting names that are not going to hurt us in a sell-off.”
So what are the guidelines that buyers of hybrids follow to avoid the pitfalls in this complex market?
The priority for most is simple: pick a good credit that won’t skip its coupons, and if you must pick up extra spread, buy bonds on which deferred coupons continue to accumulate.
“All the other, technical aspects are finer points rather than decision makers,” says Gregory Turnbull-Schwartz, fixed income investment manager at Kames Capital.
“We prefer higher-rated, repeat issuers whose rationale is to fund capex rather than investment-grade rating preservation,” agrees Sandeep Bhatia, European head of alpha strategies at SSGA. Utilities fit that bill admirably, and some telecoms – but clearly not the likes of KPN.
Beneath that, the second most important guideline is the issuer’s incentive to call its bonds at the first opportunity. Is it a regular issuer? “If you intend to keep coming back to market you don’t want a reputation for disappointing your investors,” as PIMCO’s senior UK credit portfolio manager Ketish Pothalingam puts it. That’s a characteristic of solid cash-flow generators with high capex demands, like utilities. But the real incentive comes from having the coupon ‘step up’, by perhaps 100 basis points, to a new level after the first-call date.
Turnbull-Schwartz cites a 2006 issue from Linde (which recently issued senior debt at 35 basis points over swaps) set to be called in 2016 on pain of a step-up to LIBOR+400.
“We’d be happy if they just left it outstanding,” he says, with a note of irony. “The odds of which are as close to zero as you can get, unfortunately.”
However, step-ups have generally come down since 2006, partly because issuers can get away with it, but also because rating agencies’ methodologies changed to ensure hybrids genuinely earn their equity content – which is to say, that investors don’t see their money for a long time.
“Led by S&P, the agencies have said that, to keep their equity credit, they have to knock out any massive incentive to call,” says Turnbull-Schwartz.
That can be a positive for investors in some existing issues, which could change from potential equity to high-yielding investment-grade debt overnight (Munro cites the example of a bond from oil and gas supplier Santos). But new issuers with any desire to get equity credit will have to offer lower step-ups, increasing the risk for investors – especially in a rising-rate environment.
“If they’ve issued a bond in today’s low-interest-rate environment and five years down the line that looks like cheap financing even with the step-up, why wouldn’t the CFO do what his shareholders expect and decide not to call?” asks Richard Ryan, director of fixed income at M&G Investments and no fan of hybrids.
In many ways, this is simply fixed-income managers wondering if they ought to buy paper that looks so much like equity. This comes across again in the third guideline that they tend to follow when buying hybrids – avoid banks.
Bank-issued contingent capital instruments (so-called CoCos) generally get written off, should the issuer’s core tier-1 capital ratio fall below a threshold. Again, the terms have shifted against yield-hungry buyers – three years ago they came with a 5% threshold; more recent issues wipe bondholders out at 7%.
That is too much like equity for many. After all, European banks sit with equity-to-asset ratios of 3-5%. Compare that Linde, whose ratio is more like 40%. With that ‘real’ equity cushion your hybrid is much less likely to feel like equity. The coupons due from Linde’s hybrid add up to just €100m, notes Turnbull-Schwartz, while its equity market capitalisation is almost €30bn.
“Linde simply wouldn’t risk even a 1% move in that market cap for the sake of deferring a couple of coupons,” he says, “whereas banks are highly-geared and regulators will pressure them to use the full flexibility.”
Some contingent capital carries even greater risk than equity, Turnbull-Schwartz continues, because they can be written down to zero, like equity, but confer no ownership rights should some equity value remain after a resolution.
“I suspected these might be attracting significant interest from equity investors,” he says, “but when I’ve asked underwriters about this the response hasn’t been clear.”
Chris Higham, corporate bond portfolio manager at Aviva Investors, is unusual in explicitly comparing the hybrid yield against the equity-dividend yield from issuers he likes – he says that around one-third of hybrids yield more than the equity. But even he likes reassurance that this isn’t really equity – he bought KPN’s hybrid because of the added cushion from its simultaneous rights issue, but not TelecomItalia, which did not raise equity, and he echoes the point about about the greater-than-equity risk in CoCos.
“CoCos are not attractive for fixed income investors, fundamentally,” he says. “But while we buy corporate hybrids very much name by name, we generally believe that this is likely to be a continuing opportunity over the next few years.”
So, pick good credits, with a clear incentive to call, that issue regularly, and that aren’t banks. Does that make hybrids a safe high-yielding opportunity? Some, like Ryan and Kuhn, need a lot of persuasion.
“There is a similarity between today’s hybrid issuance and the 2007 environment,” says Ryan. “We’d be foolhardy to believe that everything will be fine this time.”
Kuhn adds: “I think that it’s absolutely possible that corporate perpetuals will not be called in five or 10 years’ time and that investors will be forced either to sell or let the issuers buy them out at a discount.”
As the rating agencies increasingly tighten the rules around equity content, perhaps bond managers should acknowledge that, outside a few core utility-sector issues, if it looks like duck and quacks like a duck, it may well be a duck.