Current environment favours corporate hybrid bonds
Low default risks, high yields and resilience to interest rate changes – these three properties are sought after in the current market environment. Investors can find these properties bundled into subordinated corporate bonds.
Hagen Fuchs and Daniele Paglia
Low default risks for companies with strong credit ratings combined with significantly higher yields make corporate hybrids attractive investment instruments. What is often forgotten is that the probability of default of corporate hybrids is identical to normal bonds of the same companies. An interesting entry opportunity is currently opening up for risk-conscious investors with a medium-term investment horizon.
At the moment, the additional return of corporate hybrids compared to corporate bonds is 2.4 percentage points. It is therefore above the long-term mean value (see chart). Accordingly, the segment currently offers an appealing premium.
Additional premium for corporate hybrids relative to corporate bonds
What's more, corporate hybrids can also compete with high-yield bonds, whose universe exhibits a significantly lower issuer quality in the non-investment-grade range. After currency hedging in EUR, they have achieved an annualised performance of 4.3% since 2011. European high-yield bonds achieved 4.5% and global corporate bonds only 1.8%.
Real estate sector as an outlier
Within the investment segment, we currently see a divided market. The real estate sector is a source of concern. Unlike securities from the rest of the market, the subordinated bonds of some of these companies are listed at a discount of 50 to 60 percent, as investors do not expect repayment on the first call date. The risk of losses in the case of REITs is therefore largely priced in, meaning that no further imbalance is expected for the asset class for the time being.
In corporate hybrids, we are positive for the closing third of the year and anticipate a performance of around six percent over the year. But we also see risks.
Focus on interest rate and economic development
On the one hand, an unexpectedly sharp rise in key interest rates on the part of the European Central Bank and the associated interest rate volatility could put a strain on the segment, albeit less strongly than broader bond funds, which typically exhibit interest rate sensitivity that is twice as high. This effect has been observed since the beginning of the year.
On the other hand, a recession that surpasses expectations could lead to a decline in the price of subordinated bonds. However, thanks to the defensive sector orientation and the strong creditworthiness of the represented borrowers, corporate hybrids are likely to perform better than bonds from borrowers with lower creditworthiness. After all, corporate hybrids are mainly issued by top European companies with correspondingly good investment-grade credit ratings. Examples include VW, Total, Iberdrola and Vodafone.
The scarce supply is proving to be technical support for the market due to the low volume of new issues. Currently, the volume of new issues is only one third of the average level of recent years. The fact that virtually all issuers are exercising their call rights on the first call date despite rising refinancing costs also supports investors' confidence in the asset class.
Summary
All in all, cautious optimism is appropriate for subordinated bonds, also because the current yield offers a comfortable buffer against any spread expansions. Nevertheless, in addition to continuously assessing the market situation, the greatest care must be taken in the selection of issuers and the analysis of the bond structure. Investors should therefore consider investing in actively managed corporate hybrid investment funds.
Corporate hybrid bonds – a brief explanation
Corporate hybrids are subordinated bonds of non-financial companies. The investment segment has become an established asset class over the past decade. The term "hybrid" was chosen because companies receive capital that is generally allocated half to equity and half to debt capital when issuing a corporate hybrid. The probability of default of corporate hybrids is identical to normal corporate bonds. Due to the subordinated structure, the bonds themselves are classified two levels lower by rating agencies. In the unlikely event of insolvency, subordinated creditors are only serviced after the secured and unsecured liabilities.
