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Euro corporate hybrid bonds - To stay over the cycle

UniCredit
By UniCredit
08 Oct 2015

The Euro corporate hybrid bond market has evolved exceptionally well since 2013, reaching a total market size of circa €85bn as of today, having become a well accepted, fairly standardised source of funding for many corporates. Featuring debt and equity characteristics alike, hybrids offer accounting, rating as well as tax benefits and create economic value for issuers. For investors, hybrids offer a welcome opportunity to diversify their investment portfolio and increase average return, but inherent risk should be eyed carefully.

Market development by issued hybrid volume    

Market development

Recent development: 2015 YTD and key drivers                               

Lining up for a third record year with €21.3bn of new hybrid supply in 2015 YTD, we expect a new record issuance in the range of €30-€35bn for full year 2015. Our forecast should be seen subject to a normalisation of market conditions, as hybrids have proved to be sensitive to market environment and negative newsflows. Uncertainty ahead of the “aGreekment” in July, China’s equity market turmoil in June through to early August, the commodity selloff and VW’s emission scandal have been heavily weighing on the hybrid market. As a result of these headlines, investors demanded well-above normal premiums to place hybrids, above the levels issuers were willing to pay. With Deutsche Boerse, Lufthansa, EDP and most recently Finnair only four corporates managed to catch a favourable issue window since Dong’s successful hybrid placement in April. To achieve a stable equilibrium between the concession demanded by investors and the willingness to pay those by issuers, market volatility should be at reasonable levels, with senior markets in full swing. We may have seen the spread lows in this year’s first quarter but in the long run markets still offer attractive conditions.

In case of a hike in rates investors are expected to be cautious and avoid buying at too low yield level at first. Issuers should react the other way round, trying to lock-in the lower coupon as quickly as possible. In such a scenario we anticipate that issuers will have to pay a decent premium to place hybrids. Once we have reached a new, higher but stable rates level, we expect supply and demand for hybrids to be similar to what we have observed recently.

In the upcoming months, we will face several call dates. In most cases we expect issuers to make use of their call right. For those, which obviously have to pay a significantly higher coupon for a new hybrid compared to the reset of the outstanding one and who would not lose the equity credit, investors should not be surprised to see issuers keeping the old hybrid in place. We are confident that a negative impact on the primary market would only arise when issuers surprise investors with a no-call. Not calling the instrument should not be a viable option for many, as loss of name-specific investor confidence would result.

Investor’s view

In a low interest rate environment the hunt for yield is the name of the game for many on the buyside.

Investors add hybrids to their debt portfolios due to the attractive pick-up versus senior bonds. This so-called sub-senior spread compensates for the risk of subordination, coupon deferability and potential extension. With ratings usually two to three notches below the senior rating, hybrids offer a welcome opportunity to invest in a lower rated and higher yielding instrument of a well known, typically IG rated issuer. Investors see this basically as a levered bond investment, clarifying the strong demand for hybrids in bullish credit markets and the industry-specific assessment. In our recent hybrid survey, investors underlined that they favour well known issuers with strong credit metrics and prefer acquisition-related hybrid offerings. The main investment driver is and remains relative value.

With hybrids’ index eligibility the product is a must-have for index-trackers and investors that are measured against usual fixed income benchmarks. Investors should, however, bear in mind the optional redemption features in case of rating methodology events, accounting revisions or changes in tax treatment. These optional calls are usually set to 101% until first call date and par thereafter, clearly raising investor concerns for hybrids which trade far above par. Dong serves as a good example of such an issuer — after loss of equity credit from S&P for its 7.75% hybrid issued in 2011, Dong had the possibility to call this hybrid at 101%. With a cash price back then around 112%, investors’ potential loss would have been significant. To ease the pain and secure positive sentiment for the replacement issue Dong went for a voluntary tender offer well above the call price at 104%. Nevertheless, we deem such investors’ last resort tender offers not as a role model for the future.

Evolution of issuer’s hybrid rationales

For many issuers the positive impact on the credit profile proves to be a driver for hybrid offerings. The positive support for leverage explains the predominant issuance of companies in the triple-B area. With current market standard documentation, rating agencies award 50% equity credit for hybrids, often easing the rating pressure for the time being. Perpetual hybrids offer equity recognition under IFRS accounting, a welcome opportunity to prep up credit metrics in case of debt financed acquisitions, investments and rising pension burden. In contrast to a mixture between senior debt and equity, hybrids are often more price-efficient and pose no dilution to the existing shareholder base. For non-rated issuers, who represent roughly 5% of total volume issued since 2003, balance sheet strengthening by additional accounted equity with positive signalling effects to lenders is the key issue rationale. Since 2013, a standardised structure — now the third generation — has evolved on the back of established rating methodologies, attracting both investors and issuers to this form of funding instrument.

Growth potential going forward

Since 2013, hybrid volumes have accounted for roughly 10% of overall corporate bond supply. Potential for growth is anticipated to derive from inaugural issues across a variety of sectors and driven by further M&A activity. Additionally, similar to issuers’ curves of senior bonds, we expect existing hybrid issuers to build up hybrid curves. By evaluating the maximum hybrid volume issuers have to consider that S&P and Moody’s cap the equity credit assigned for hybrids. While the Euro senior bond market is partly driven by non-European issuers (circa 25% of total issue volume), the hybrid market lags behind with only a few international corporates accounting for 6% of total Euro hybrid supply since 2013. Some additional growth is expected to come from non-rated issuers. However, we deem investor demand for non-rated subordinated paper as limited. The expected refinancing of outstanding hybrids with first call dates from 2018 onwards will certainly boost primary market activity going forward. Non-calls should be even more a non-viable option, as next to name recognition by investors, many of those hybrids loose equity credit at the first call date.

Call dates of outstanding EUR corporate hybrid bonds    

Call dates of outstanding EUR corporate hybrid bonds

Investor demand clearly indicates further hybrid market growth. Strong orderbook oversubscription and the high number of investors involved underline that the market is receptive for higher yearly volumes as seen since 2013. With respect to issue windows, we expect new hybrid volumes to be high in bull markets and close to zero in volatile and deteriorating markets.

Overall, we anticipate that hybrid instruments will be even more frequently used as a standard financing tool by various corporates. Total issue volumes are estimated to range between 10% and 15% of overall EUR corporate bond supply going forward.

Authors: Lars Veltmann, Ulrich M. Simon and Christian Schneeberger, Corporate Hybrid Capital Structuring, UniCredit Corporate & Investment Banking

By UniCredit
08 Oct 2015