18th May 2018
Why are they issued?
Corporate Hybrids are a maturing area of the global fixed income universe that have formed a key part of the Rubrics Global Credit strategy for over six years. These instruments enable corporates to issue tax deductible debt which also benefits from equity credit standing from the major rating agencies. As a result, when used judiciously, corporate hybrids can lower a company’s weighted average cost of capital. Issued predominantly by European and Asian non-financial corporates, the bonds are callable subordinated issues typically possessing a first call date of between five and ten years. Corporate hybrids can be attractive for investment-grade companies as they represent an alternative to either (more expensive) non tax deductible equity or can help support a company’s senior unsecured ratings. Over the years we have seen hybrids used for both of these purposes.
Why are they attractive?
Typically these bonds offer a spread pickup over an issuer’s senior unsecured IG rated paper which has historically been in the range of 0.5 to 1.0x higher. Generally, the credit rating on a corporate hybrid tends to be around two notches below the issuer’s senior unsecured rating. For example, BHP possesses an A- rating at S&P and its corporate hybrid paper is rated BBB.
In addition to valuation considerations, the “rating agency motivated” element of issuance makes it very likely that the issuer will call the bond at first opportunity. If not called at their first call date, typically these instruments lose equity credit from the perspective of the rating agencies – provided the issuer possesses a senior IG rating at the time. They would then become de facto senior funding on the issuer’s balance sheet from a rating agency perspective. The loss of equity credit would destroy the entire commercial rationale of issuing the instruments in the first place and would likely leave the issuer saddled with paying an interest rate significantly higher than that of senior unsecured debt.
Recent positive issuer activity
Over the past year, several corporate hybrid issues have called bonds at contractual first opportunity. Examples of such holdings within the Rubrics product suite include those from BG Group, SSE, Hutchison Whampoa and OMV.
Due to rating agency methodology changes it is now also possible for corporate hybrid issuers to engage in opportunistic Liability Management Exercises (“LME”) on legacy hybrid paper in order to retire more expensive debt and re-finance hybrids with new lower coupon hybrid debt. So far in 2018, two of the Rubrics Global Credit UCITS Fund’s corporate hybrid investments have been the beneficiary of LMEs:
i) In March 2018, Telefonica launched LMEs on several of its hybrids including the Telefonica 6.75% GBP corporate hybrid with a contractual first-call date of November 2020. The Rubrics Global Credit UCITS Fund possessed a 1.4% position in this bond and we duly tendered our entire holding at an attractive exit price.
ii) Just this week, Italian Energy company, Enel announced that it is carrying out an LME on some of its older high coupon Hybrid bonds in order to issue new securities at lower coupons. The Enel 6.5 € corporate hybrid that was scheduled to be contractually called in January 2019 is one of the largest holding in the Rubrics Global Credit UCITS Fund and a core holding of the Rubrics Global Fixed UCITS Income Fund. The bond is now the subject of an “any and all” LME at an anticipated exit price of 104.11 plus accrued – equivalent to an attractive exit yield of 0.00%. Tendering this bond is potentially beneficial in three main ways:
- Being paid an attractive premium to market price to exit the position
- Liquidity – efficiently frees up cash for the fund
- Creates optionality to invest in to more attractive, higher yielding risk-adjusted bonds
Rubrics investment approach to Corporate Hybrids
It is important to note that not all corporate hybrids have been created equally and investing requires careful selection. It is best to avoid investing in issues where there is either a realistic prospect of the issuer’s senior unsecured rating being downgraded to high yield (as in these instances the hybrid retains equity credit and is less likely to be called) or if contractual re-set pricing is comparatively low.
2017/18 saw many new Corporate Hybrids issued, however we were not active in the new issue space as most new issues did not possess the characteristics we desire.
This is not to say that “new” Hybrids have not been popular with other investors. For example, the Corporate Hybrid by Danone issued in Q3 2017 had book size of EU 7.6bn (6x covered). The concerns we have that particular issue were:
- Low coupon (1.75%)
- Low reset (5 year EUR Swap + 1.428) at the first call date, then reset increases in subsequent resets
The Danone bond would have been popular for benchmark driven Euro Managers looking for a spread over Bunds, which at time of issuance was +142 over mid swaps. However, being a total return, non-benchmarked investment manager, Rubrics did not buy this bond given the scope for potentially increased mark-to-market risk if more challenging market conditions eventuate
Our strategy remains to stick to our strict investment criteria on Corporate Hybrids on solid credits with high re-set spreads, such that we continue to generate attractive risk adjusted returns with minimal tail risk (extension risk).
Important Investment Information The views above are published solely for information purposes and are not to be construed as a solicitation or an offer to buy or sell any securities, or related financial instruments. It does not constitute advice or a personal recommendation as defined by the Financial Conduct Authority (“FCA”) or take into account the particular investment objectives, financial situations or needs of individual investors. The views above are based on public information and sources considered reliable. Past performance is not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments can fall as well as rise, therefore you could get back less than you invest. If you are unsure about the appropriateness of an investment for your circumstances please seek independent financial advice. Investors should form their own view on any proposed investment. This publication has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Figures correct as at 17 May 2018 unless otherwise stated. This publication is issued by Rubrics Asset Management, an appointed representative of Shard Capital Partners, 20 Fenchurch Street, London, EC3M 3BY United Kingdom who are authorised and regulated by the Financial Conduct Authority. For South African investors: In the Republic of South Africa this fund is registered with the Financial Services Board and may be distributed to members of the public. In addition to the other information and warnings in this document, the Financial Services Board of South Africa requires us to tell South African recipients of this document that collective investment schemes are generally medium to long-term investments, collective investment schemes are traded at ruling prices and can engage in borrowing and scrip lending and that a schedule of fees and charges and maximum commissions is available on request from the manager. Because foreign securities are included in the investments within this collective investment scheme, we are also required to disclose to you that there may be additional risks that arise because of events in different jurisdictions: these may include, but are not limited to potential constraints on liquidity and the repatriation of funds; macroeconomic risks; political risks; foreign exchange risks; tax risks; settlement risks and potential limitations on the availability of market information. Additional Information for Switzerland: The prospectus and the Key Investor Information Documents for Switzerland, the articles of association, the annual and semi-annual report in French, and further information can be obtained free of charge from the representative in Switzerland: Carnegie Fund Services S.A.,11, rue du Général-Dufour, CH-1204 Geneva, Switzerland, tel.:+41227051178, fax:+41227051179, web: www.carnegie-fund-services.ch. The Swiss paying agent is: Banque Cantonale de Genève, 17, quai de l’Ile, CH-1204 Geneva. The last share prices can be found on www.fundinfo.com. For the shares of the Funds distributed to non-qualified investors in and from Switzerland and for the shares of the Funds distributed to qualified investors in Switzerland, the place of performance is Geneva.