Hybrid bond issuance has started to grab headlines again. The last month has seen a few companies start to issue the centaurs of the bond world again. But are they a good investment?
We wrote about hybrid bonds back in April, suggesting that they could potentially be a good source of alpha if investors do their homework. Hybrid securities have features of both equities and bonds, and like equity they don’t mature (although some do have call features) but pay a coupon like a bond. The legal language, bond covenants, incentives for the company to call the hybrid and rights of the bondholder in the event of a default can differ considerably from issue to issue.
Hybrid bonds are treated as debt for tax purposes, and depending on the individual structure can be treated as equity by credit rating agencies. Because the rating agencies give credit to hybrid deals for their equity features, they do not put downward pressure on a company’s credit rating like all-debt deals can. Ratings agencies like them because should a company get into financial difficulty, it could choose to simply not call the debt or stop paying coupons to hybrid bondholders. This is attractive for the issuer but if the coupon gets deferred what investor would want to hold a zero coupon bond in perpetuity?
On Monday RWE – a German utility – issued a hybrid bond at B+322bps which is a yield of 4.7%. 5yr CDS for RWE (a rough proxy for what it would cost them to issue senior 5yr paper) was trading around the 65bps mark. Not a bad yield pick-up for an investor, and the credit rating companies are happy as well. This brings us onto the potential upside for the bond investor. If you pick the right company and the right hybrid bond, you may be rewarded with an attractive yield relative to senior bonds that have been issued by the company.
But perhaps hybrids aren’t quite the panacea they are made out to be. Are investors better off simply investing in a company’s equity and participating in potentially unlimited upside from the share price going up?
Traditionally it has been financial firms at the forefront of issuing hybrid bonds, but the uncertainty of the regulatory outlook at present has all but halted issuance from this part of the capital structure. On September 12th the Basel Committee announced that any newly issued hybrids will not receive any capital credit from financial regulators. As some of you may be aware, a rally in tier 1 and tier 2 securities has followed – the overriding sentiment in the market was that banks would start calling these instruments at the earliest possible opportunity.
So the centaurs are coming back – but be careful which horse you choose to ride as you may get bucked off.