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The Story of Hybrid Capital

By Vianney Hocquet, Portfolio Manager, Pioneer Investments

After a good performance in 2015, subordinated securities have had a challenging start to the year in 2016.

Concerns around global growth, not just in Emerging Markets but also in the US, uncertainty on central banks actions, alongside a repositioning in lower “beta” assets have been in the key drivers of the correction.

In our view, however, these assets will increasingly become central to any credit investors’ portfolios going forward.

Key features of subordinated debt

Subordinated debt sits between senior debt (which ranks at the top of an issuer’s capital when a company is liquidated) and equity (which ranks last) and therefore enjoys features that render it a “hybrid” combination of both asset classes.

The most common features are:

(i) it pays coupons, but these coupons can – to a varying degree – be skipped by the issuer without that triggering a default

(ii) it is permanent capital (i.e. has very long maturities), but has earlier call dates more akin to those of senior bonds

(iii) it contributes (partially) to the capital of issuers from a regulatory or rating agencies perspective

(iv) returns from these securities are higher than those of senior bonds and lower than those of equities. (Its return incorporates a “subordination premium” - a new element in addition to the “risk-free” rate and the “credit spread” enjoyed by corporate bonds).

A brief history of subordinated debt

Subordinated debt has existed for quite some time. From Preferred Securities in the US to “old-style” bank subordinated debt, investors have had the opportunity to access this asset class for many years now. However, the resurgence of Corporate Hybrid bonds as an asset class, mainly in Europe, after 2012, combined with the new bank capital regulations following the Global Financial Crisis, has given rise to a broader, more diversified and arguably more complex investible universe.

The option of issuing hybrid debt has, historically, been met with lukewarm interest by non-financial companies – partly because the rating framework for these securities was not homogenous enough.

Once the rules became more harmonised and accounting treatment clearer, more corporate issuers have come to this market and issued hybrid securities to protect their rating profile (an equity credit is granted to these securities), diversify their funding structure and help fund M&A transactions together with (senior) debt and equities.

The Global Financial Crisis demonstrated very clearly that the “old-style” subordinated structures were not easy to bail-in.  Consequently, the burden to recapitalise banks fell entirely onto Governments and, to a lesser extent, shareholders. In short, these instruments failed to perform their main (some say only) purpose, that of providing a cushion to absorb losses and prevent banks from going into distress.

New structures were, therefore, introduced by the Basel III committee and the CRD IV directive, giving rise to a new set of instruments: Contingent Convertible bonds – known as Cocos, these are bonds which could easily be converted into equity (or written down) should the regulator say so, or if the capital levels fell below a certain threshold (the so-called “trigger level”).

The growth of the asset class – Great Past but does it have a Future?

The Corporate Hybrids universe has grown from less than €25bn in 2011 to more than €100bn currently, while “new” bank subordinated debt stands above €250bn and is expected to account for at least 3.5% of global banks’ total Risk Weighted Assets in coming years.

Corporate hybrids have been shown to protect the investor quite well (coupons can’t be cancelled, only deferred). This kind of situation is perfect for investors during an economic growth phase or in a low volatility environment.

However, the issuance of corporate hybrids can sometimes be interpreted as a negative signal: it suggests that when an issuer is releveraging, it wants to keep its rating but is not in a position to forecast significant deleveraging in the short term. We expect issuers to continue issuing Corporate Hybrids to diversify their funding structure and protect their ratings – although M&A presents a major swing factor to our forecasts, as this may drive issuance above or below our expectations during the year.

Financial subordinated debt do not have this signalling effect but comes with harsher clauses, which are part of the regulatory requirements. We also expect issuance to continue despite the fact that banks are currently under scrutiny: the regulators clearly have a vested interest in allowing and facilitating the issuance of further AT1s and T2 in the coming months. 

Recent clarifications from the regulators have also suggested that the ability to automatically skip coupons, by banks reporting poor results, will be a bit more difficult to trigger.

Going forward, with Central Banks retaining a pronounced easing bias and investors seeking returns in an environment of exceptionally compressed yields, we expect demand for the Subordinated debt asset class as a whole to remain sustained over the foreseeable future.

High Risk, High Returns: what is needed for the asset class to perform? What should investors be mindful of?

The asset class offers a very significant yield pick-up over European IG Credit – with Corporate Hybrids yielding around 4% and Cocos yielding slightly below 6.5%. We consider the weakness at the start of the year to be a welcome correction which has allowed risks to be repriced properly – and we now consider the risk-reward of the asset class to be much more compelling.

Demand for the asset class should be sustained in the foreseeable future, as investors have grown increasingly familiar with the assessment of the structures and are now keen to exploit the valuation differential between senior and subordinated spreads, which in our view is approaching interesting levels.

If the regulators and rating agencies leave the key rules of this market unchanged, we expect the subordination premia to attract sophisticated investors into the asset class and should help it perform in the near future.

As regards the risks, investors need to be mindful of some general risks as well as some very specific ones.

(i) Credit analysis is of paramount importance: credit investors expect coupons payments and principal repayment at redemption, and it is important to note that subordinated securities are still bonds;

(ii) Understanding the legal documentation of the subordinated bond: this analysis is very complex, because investors need to be able to assess the implications of any credit events that the bond prospectus provides for as well as the potential effect on the price of the bond and whether that is reflected in the relative value of the bond;

(iii) The likelihood of the bond being called at the first call date: the difference between the spread of a subordinated bond trading to the call date and one trading to maturity is extremely significant. Investors need to be very confident about the possibility of a call at the first call date when they invest – and an assessment of not only the intentions of the management team but also the economic implications of a call are crucial when assessing the decision to invest in subordinated bonds;

(iv) The regulatory framework: the main risk, as regulatory driven bonds, for both financial and non-financial subordinated bonds is the uncertainty about rules. Ratings agencies (some more than others) still change their methodology for corporate hybrids. Banking regulators are also constantly changing capital requirements, how it is broken down and distribution rules.


This content is provided by Euromoney Seminars for informational purposes only, and it reflects the market and industry conditions and presenter’s opinions and affiliations available at the time of the presentation.