Investors wake up: hybrid capital is not a free lunch
Subordinated corporate debt investors are stuck in a quantitative easing mindset
There is a persistent belief among investors and bankers that corporate hybrid capital is essentially just senior debt with a bit of extra yield. This outdated thinking is damaging to one of the most protective financing tools in a treasurer’s toolbox.
Up to €30bn of European corporate hybrids are expected to be issued in each of 2023 and 2024, just to refinance old bonds — almost triple the volume issued in 2022.
Bankers are already fretting that there will be so much supply that investors will be picky in the hybrids they buy, putting even more pressure on out of favour issuers, such as those in the real estate sector.
But another problem is bubbling below the surface of the market.
There is still a common belief among bankers and investors that investing in hybrid debt is basically the same as buying the company’s senior debt, with a tasty slug of extra yield.
This is clearly untrue. Companies such as Spain’s Ferrovial and Germany’s Aroundtown have recently decided not to call hybrids on their first call dates. Aroundtown has even considered deferring coupon payments. These moves are permitted under hybrid documentation.
The problem with assuming a hybrid is just senior plus yield is that when call dates pass without a call or coupons are deferred, investors that went into the deals thinking such actions were so unlikely that they could be dismissed will see their risk models disintegrate.
While these events remain rare, hybrids can in theory become perpetual bonds. How does an investor expecting ‘senior risk plus yield’ possibly account for that?
Disappointments and shocks to investors with the wrong expectations could sour sentiment towards hybrids, just when a huge refinancing wave is inching closer to the market.
Hybrids pay extra yield because they carry much higher risk. It was easy to forget that while quantitative easing smoothed over every crack in the market. Those good times are over.
As the bank capital market has shown, with the wiping out of Credit Suisse’s Sfr16bn ($17.8bn) of additional tier one capital, hybrid debt is meant to absorb risk, and it does. Investors must buy with their eyes open.