7 Questions To Understand Corporate Hybrid Bonds

1. What are corporate hybrids?

Corporate hybrid bonds are subordinated debt instruments issued by non-financial companies, known as ‘Corporates’.  All hybrid issuers are Investment-Grade rated at the time of issuance. Such bonds are known as ‘hybrids’ because they combine the characteristics of bonds (payment of a coupon) and equities (no maturity date or a very long maturity; the issuer may decide not to pay the coupon, as may be the case for dividends).

Rating agencies regard Corporate hybrids as half-debt and half-capital, applying the concept of ‘Equity content’, which tends to improve the issuer’s credit ratios.

2. Although hybrid bonds are ‘perpetual’ – or with a very long maturity, can the invested capital be recovered without selling the bond?
 

•  Yes, there is a call date, which falls between 5 to 12 years after the issue date. If the issuer exercises the call, the investor shall be paid back fully at a price of 100%. It is a market convention that Corporate hybrids are normally redeemed at their first call date. There have been only a very few cases when issuers have not exercised the call, arising during a recession, and when the issuers in question have seen their rating downgraded to the HY category.
• Hybrid issuers also actively manage their debt through liability management before the first call date to refinance at a lower cost. In this case, the offered price would provide a premium to the last trading price. Investors may decide whether or not to accept the offer, but after this operation, the hybrid would be less liquid. 

3. What are the advantages for the investor?
 

• A way to invest in a solid issuer: Corporate hybrids are issued by IG-rated companies, implying relative stability and a sound financial profile of an issuer, reflected in its credit ratings (capacity to generate consistent operating cash flows).
• A way to obtain higher remuneration: hybrids offer an attractive yield compared with senior bonds. The yield pick-up between the same issuer’s senior bond and hybrid, with a first call date equalling the senior bond maturity, depends on market conditions. This credit spread exists as hybrids are subordinated instruments and, by nature, carry several risks.
• A relatively low risk, on condition that they benefit from a strict selection. Extension risks and coupon deferral risks are very rare for strongly IG-positioned issuers. Moreover, according to the methodology of Standard and Poors (S&P), hybrids lose their ‘Equity content’ after the first call date, as long as the issuer remains IG-rated, which is a push for a call at the first call date. The issuer’s market reputation must also be considered.
• Should a coupon deferral event occur, coupon payments to the hybrid-holder must be paid on a cumulative (and in some cases compounded) basis as soon as the issuer is in a position to pay a coupon again.
• An opportunity to invest in ‘Green’ hybrids, as the bulk of new hybrid issues now have a ‘Green Bonds’ format. 
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4. What are the characteristics of the Corporate hybrid market?
 

• After strong growth since 2013, Corporate hybrids are now a mature market. In 2021, the total value of the hybrid market has reached €190bn, a sharp jump from €20bn in 2013. Its investor base is solid.
• The number of issuers and hybrids has grown rapidly, as the market is embracing a large number of sectors. However, the main sectors are Utilities and Telecoms, as Capex in these sectors remains substantial.
• The market is mainly in euros. Other currencies used are USD, GBP and marginally CHF, in that order of volume. 
• It is a fairly liquid market: issues often have a ‘benchmark’ size (i.e. €500 million or above), with prices quoted within a fairly tight bid/ask range.
• Primary intensity (new hybrid issuances) can be irregular and depends on market conditions.
• Finally, the bulk of new hybrid issues now has a  ‘Green Bond’ format. 

5. What are the risks associated with holding Corporate hybrid bonds?

• Credit risk: this is a major factor. While this risk is quite small for hybrid issuers that have a strong Investment Grade rating, the risk is higher for low-BBB rated issuers during a crisis.
• Interest rate risk: the price of hybrids which have a long first call date is more sensitive to interest rate fluctuations.
• Subordination risk: hybrids are subordinated debt instruments. This means that their rating is, on average, 2-3 notches below the senior debt of the same issuer. (They are often rated High Yield). Should the issuer default, the rate of recovery for holders of hybrid securities is usually quite low as senior debt holders take priority (first in line after the payment of salaries, taxes and any secured debt). However, defaults by issuers with an Investment Grade rating are extremely rare.  
• Extension risk: an issuer may decide not to call the hybrid at its first call date. This risk is structurally low, but when it does occur, or if this scenario is anticipated by the market, the price of the hybrid may fall by some 10%. This event may arise when the issuer’s rating is downgraded to High Yield, reflecting a credit deterioration since issuance. However, cases since 2013 have been rare.
• Lower coupon when reset: if the hybrid is not called at its first call date, the fixed coupon is systematically re-calculated, and becomes a coupon providing a floating rate and based on money market rates or long-term Swap yields. When reset, it can be much lower than the initial fixed coupon and trigger a sale in the market by investors.  
• Deferral of the coupon payment: an issuer may decide not to pay one or several coupons of its hybrid(s). This risk is very low (lower than the Extension risk) during periods of economic growth but this scenario may arise if the issuer encounters severe liquidity difficulties. This scenario only materialises when shareholder remuneration is suspended. Such event seriously damages the issuer’s reputation, thereby reducing its capacity to borrow on the bond market in the future.  
• Early call risk: again, it is at the issuer’s discretion. Some specific clauses in the issue prospectus may stipulate a trigger of an early call at 101% in the event of methodological/tax/accounting changes. Therefore, it will impact hybrids trading at a high cash price. But there are no methodology changes (from rating agencies) as long as the issuer replaces a hybrid called at the first call date with another hybrid.
• Volatility risk: Corporate hybrids are positively correlated to the equity markets. During periods of risk aversion, share prices fall and the credit spread on hybrids widens, as yields rise and hybrid prices fall. 

6. When may it be tricky to be invested in hybrids? A worst-case scenario.

An opportunistic issuer on the hybrid market (BBB-rated with a negative outlook) is facing a strong credit deterioration. Its credit rating has been downgraded by S&P to the HY (High Yield) category. Consequently, the probability of a non-call at the first call date increases. The issuer finally decides not to call at the first call date: as the issuer is HY-rated, S&P extends the ‘Equity content’ for the five subsequent years. Therefore, despite other call dates that may be sooner, the hybrid may not be called during those five years. The fixed coupon, re-calculated as a floating coupon, is linked to the 3-month euro rate plus a small margin (+130bps, for example). Therefore, the coupon falls from around 2% to 0.70%, which contributes to the acceleration in the price fall. Finally, the issuer encounters more serious operating difficulties, and decides not to pay hybrid coupons in order to preserve its liquidity position. The cash price of its hybrid loses value again in the market, and the hybrid becomes illiquid. Lastly, the situation persists, as these events are not considered to be an issuer default.

7. Is there any guarantee that the coupon will be paid?
 

• BNP Paribas Wealth Management’s bond experts follow the financial profile of issuers and assess the capacity of their financial profile to withstand a recession or market crisis (e.g. do they have the capacity to preserve their liquidity situation?) and avoid a sharp downgrade by rating agencies.
• We prefer to select hybrid issuers that are going to remain IG-rated (irrespective of the macroeconomic context) and enjoy a sound liquidity situation. There are very few other risks for an issuer which is (and will remain) IG-rated by S&P.
• Moreover, for this bracket of issuers, it is possible to select hybrids with an IG rating despite the fact that hybrids’ ratings are often rated in the High Yield category (a hybrid’s rating is always two or three notches below the issuer’s rating).
• If the hybrid is not called at first call date, the coupon is recalculated and becomes a floating coupon. This new coupon can be linked to money market rates or to long-term Euro Swap yields to which a margin is added. It is BNP Paribas Wealth Management’s role to calculate whether this margin sufficiently remunerates the risks associated with each hybrid, reducing the likelihood of a ‘non-call’ at the first call date. 
• Expertise is also essential for hybrids that are only rated by Moody’s or Fitch, or even not rated (NR).
• In the current macroeconomic context (we are now in a recovery phase), we have quite a large number of Corporate hybrids on our Buy list. Furthermore, we also recommend a selection of funds, which are partly invested in hybrids.

Thierry Trigo