Analysis
By Camille Suh, Fund Manager and Corporate Credit Specialist at Lazard Frères Gestion
Halfway between securities and bonds, the “corporate hybrid” market offers a solution for investors in search of a good balance between risk and return. These products, while still not widely known, offer serious benefits when it comes to diversifying a bond portfolio.
In recent years, the hybrid market has flourished, growing from a market size of around €30 billion in 2012, to €190 billion in 2021[1]. The segment is increasingly gaining the attention of issuers as well as investors.
Unique in their kind
These bonds are known as “hybrid” because they have certain features specific to debt instruments (coupon and early repayment option) while at the same time sharing some of their features with securities (perpetual or very long maturity). Furthermore, hybrids come with clauses in their coupons allowing payment to be deferred if the issuer is unable to pay its dividends.
Ratings agencies therefore only view hybrids as fifty percent debt, with the other half being treated as equity, thereby allowing the issuer to improve its credit ratios. Despite a long maturity, hybrid debt is associated with early call dates, which are indeed nearly always applied. In fact, once the first call date has passed, the ratings agency S&P excludes hybrid bonds from its equity calculations, which lowers the interest for the issuer.
Usually issued by investment grade entities, hybrid debt allows a company to retain its high rating by bolstering its equity without diluting its shareholders, which in turn improves its balance sheet and credit ratios. The subordinated nature of hybrid debt encourages ratings agencies to rate them 2–3 notches lower than senior debt from the same issuer. Hybrid debt therefore offers higher returns, meaning a higher cost for the issuer but one which is nevertheless still reasonable given the benefits.
As for investors, they view corporate hybrid bonds as a way of generating additional yield in return for a controlled, albeit higher, risk. These securities come with higher volatility and returns than those from the Investment Grade segment, but without carrying the same risk of default or even the same volatility as the High Yield segment[2]. Hence the appeal of hybrids for investors in the current low-rate environment.
The hybrid family wins hearts and minds, and gains market share
The year 2020 broke all records. New hybrid issues totalled around €47 billion, of which 85% were denominated in euros1. This represents growth of approximately 50% since 20191. There are many reasons behind this success. First, issuers regularly refinance their hybrids to keep them permanently within their capital structure while at the same time benefiting from their classification as half equity/half debt. Second, the economic shock of Covid-19 has prompted certain companies to turn to the hybrid market as a way of shoring up their balance sheet at a reasonable cost.
Several years ago, two sectors dominated the hybrid debt segment, namely utilities (electricity, gas, water, waste processing) and telecoms, seeking long-term funding for their infrastructures. There is now a much more diverse range of issuers. In 2020, the energy sector significantly increased its share with inaugural issues from BP (United Kingdom) and Eni (Italy). The utilities sector remains dominant (30% of the market), but the energy and telecoms sectors are hard on its heels (18% each). [3]
Recently, some hybrid products also qualified for the “green bonds” category. In 2020, issues of “green” hybrid debt reached approximately €4 billion. [4] This approach, which is likely to see significant continued development over the next few years, makes it possible to invest responsibly in hybrid debt while complying with environmental, social and governance (ESG) criteria.
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See also: https://latribune.lazardfreresgestion.fr/en/japanese-markets-enter-a-new-era/
Risks specific to the hybrid segment: credit risk, rate risk, subordination risk, extension risk, coupon deferral risk, volatility risk, discretionary management risk.
Article written on 8 June 2021. The information provided is not intended to constitute investment advice and is intended for information purposes only. The data used in this document is used in good faith, but no guarantee can be given as to its accuracy. All data contained in this document, unless otherwise indicated, comes from Lazard. Past performance is not a reliable indicator of future performance. The opinions expressed in this document are subject to change.
[1] Sources: Ice BofA, Bloomberg (May 2021). Figures converted to euros.
[2] For more information, read Qu’est-ce que le High Yield ? (What is High Yield?) at latribune.lazardfreresgestion.fr.
[3] Sources: Bloomberg, 2nd of June 2021
[4] Sources: Bloomberg, 2nd of June 2021
