Wednesday, 26 September 2018

Thriving hybrids

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  • European corporate hybrid issuance volumes

The corporate hybrid market is enjoying a mini-revival having reopened last month in Europe amid a great deal of fanfare. The structure offers obvious benefits for issuers and investors alike in the current low interest rate environment. Bankers are braced for one of the busiest periods for corporate hybrid issuance since the onset of the credit crisis in 2007. Andrew Perrin reports.

Despite a macro-economic picture that is far from certain, bond markets throughout the globe have been firing on all cylinders since bankers returned from their summer vacations. And while September is generally a month of heightened activity – it would have been more noteworthy had the expected business not transpired – the sheer scale of investor appetite has been notable. It has been well known that investors have been cash rich, but their renewed enthusiasm has skewed the demand/supply dynamic, creating some very interesting trends.

One development is the proliferation of new structures now on offer, of which the re-opened European corporate hybrid market is one. Ithas once again established itself within the capital structure for European corporates that are looking to raise funding while preserving their credit ratings. It has traditionally been viewed as a bull-market instrument, given that exposure is deep down in the company’s capital structure. But it is enjoying a resurgence because investors are looking for incremental returns in the persistent low interest rate environment, that is accompanying the prevailing global uncertainty.

“The European investor base has evolved as their perception of risk has changed in an environment of sluggish economic growth,” said Christopher Marks, global head of DCM at BNP Paribas. “Fears about the heath of peripheral sovereigns and increased talk of a re-composition of bank capital have geared more investors towards a broader range of corporate exposure, and the more subordinated the better in this low rate environment.”

Things got off to a promising start in February 2010 when Dutch state-owned electricity company TenneT’s €500m perpetual NC7/NC12 transaction, the first corporate hybrid for 18-months, garnered robust demand of about €3bn from an enthusiastic band of investors. However, despite the positive reception the deal received, it remained the only corporate hybrid until July.

Ratings clarification

This was not due to a lack of interested candidates. Rather, there was a lack of consistency as to how the structure was treated by the rating agencies. It is a scenario that has often plagued the market’s development in the past. However, participants breathed a collective sigh of relief in July when Moody’s revealed that its long-awaited framework for assessing the equity and debt characteristics of hybrid securities was unlikely to trigger significant changes in the credit ratings of companies that issue these securities.

In line with expectations, Moody’s maintained its existing baskets of “A” to “D”, but the new system means that those hybrids with greater loss-absorbing characteristics will be notched wider than those without. They will therefore receive more equity credit. Importantly, the agency also confirmed that it will not grandfather the existing basket treatment for outstanding hybrids because it cannot be justified analytically.

This paved the way for the market to re-open. But a decline of risk appetite on the back of renewed peripheral sovereign fuelled volatility, coupled with the cancellation of a planned issue from Dutch utility Eneco, ensured the market remained in limbo. This lasted until Scottish & Southern Energy got the ball rolling with its dual-tranche Perpetual NC5/NC10 euro/sterling hybrid in early September. This was quickly followed by subsequent euro benchmarks from Suez Environnement and RWE as the utilities continued to dominate supply.

“These utilities are well regulated stable credits offering an attractive rate of return and as such provide the ideal issuers to kick-start the market,” said Mark Lewellen, head of European corporate origination at Barclays Capital.

This was reiterated by Chris Higham, fund manager at Aviva Investors. There is “a lack of opportunities to lock into a yield of over 5.0% for an assumed five-year maturity and a stable credit [like SSE] that we are fairly constructive on,” he said. There has also been a general lack of any kind of European corporate supply in recent months, especially in the sterling market. That, along with ongoing volatility in equity and CDS markets, has accentuated demand for low-beta corporate debt in general, he said.

Enticing the investors

Ed Farley, portfolio manager and head of European investment grade at Pramerica, also cited the attractive yield on offer for the defensive low beta utilities. But an investor friendly structure is also very important, he said.  

“As a fixed income investor you want the instrument to be as favourable as possible and that means ensuring that any optionality comes at a cost to the issuer,” he said. “Those 50% equity credit issues that are rated by Standard & Poor’s with a dual call structure and replacement capital covenant demonstrate a strong intent to call the instrument on the first call date, and therefore accommodate investors in this regard. They have consequently become an established blue print for the utility sector.”

While the returns on offer are clearly attractive to yield-hungry investors, the structure also makes sense for issuers. Hybrids offered the utilities extremely low all-in costs of funding by historical standards, which is actually cheaper than many were forced to pay to raise senior funding just last year. The euro tranche of SSE’s dual currency euro/sterling issue paid a coupon of 5.025%, the second lowest on a euro-denominated hybrid since Bayer issued its 100-year/NC10 issue with a 5.0% coupon in July 2005, for example. This was subsequently beaten by Suez Environnement that secured coupons of 4.82% and 4.625% respectively.

All this is expected to tempt more companies to the market in the coming weeks. There is already a growing number planning investor roadshows or structuring deals. The utility sector is likely to drive this supply, predicted Barclays Capital’s Lewellen: its heavy capital expenditure requirements cannot always be fulfilled by equity shareholders.

“The hybrid structure is one of a number of tools that corporate treasurers have available to capitalise in the low rate environment,” said Marks. “At the moment we are still almost exclusively operating in the utility space but should begin to move into other regulated industries and perhaps some retail driven issues. This in turn could provide an outlet for other more adventurous and challenging credits.”

Another credit that has already embraced the structure is Australian oil exploration and production company Santos, which chose the asset class to make its Eurobond debut. But any fears that accounts would baulk at gaining their first exposure to the name so far down the capital structure were soon allayed by demand that topped €1.5bn for its 60-year non-call seven transaction. This was despite the bonds being structured to obtain 100% equity credit from Standard & Poor’s, meaning they were rated four notches below the company’s BBB+ senior level.

“The reception illustrates the huge demand for yield in this low interest rate environment from investors that still appear to have lots of cash to put to work. They are happy to channel this into less familiar non-frequent issuers, offering a higher equity content at sub-investment grade,” said Joern Felgendreher, vice-president, portfolio management fixed income at DWS Investment.

Classic buy-and-hold retail investors should be less rating-sensitive, as long as the yield compensates for fundamental credit risk and structures exclude non-cumulative coupon deferral risk, he said. “We would expect to see retail investors remain receptive to these risk/reward opportunities even if the economic outlook deteriorates.”

A note of caution

However, not everyone has embraced the return of the structure so fervently. Some investors remain unconvinced, and are mindful of past losses. “While some issuers, such as utilities, are suitable candidates for selling hybrid structures, the performance of such debt previously should not be forgotten,” warned Georg Grodzki, global head of credit research at Legal & General.

While mark-to-market losses were lower for corporate than for financial hybrids, they were still painful, he said. Their borderline ratings naturally exposed them to heightened junk risks, whether in a downturn or when rating methodologies change.

“With the number of candidates understood to be growing in this particular sector, it is imperative that the credit assessment of such issuers is given sufficient emphasis, despite the natural inclination of some asset managers to search for incremental yield,” he said.

While investors remain hungry for yield, the sector is set to remain interesting. However, hybrids do present additional risk, said Pramerica’s Farley. While there is a place for them in the portfolio, it’s not an asset class that he would want to be too overweight, regardless of the interest rate environment.

“Hybrids will always trade in a multiple to senior debt and are therefore more volatile instruments in a bearish market, so while they do have a place, its important not to get too carried away,” he said.

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