The spread difference between corporate hybrid and senior bonds has been squashed to its tightest level ever. Borrowers should take advantage now, as it cannot last.
Investment grade companies in Europe have been printing hybrid capital at tighter and tighter spreads over their senior bonds for months now.
But Japan Tobacco grabbed attention last week by printing a €500m 30 year non-call 5.5 hybrid only about 70bp wider than where its senior bonds were trading. The lead managers claimed it a record.
This week, Danone went further, selling a €500m perpetual non-call seven year hybrid around 70bp over senior. Not only did this deal have a longer non-call period than Japan Tobacco's, but Danone is much lower rated. Its hybrids are Baa3/BBB-, compared with Japan Tobacco’s A3/A-.
Not every deal comes quite this tight: Evonik’s €500m 30 year non-call 5.75 on Tuesday appeared to land with a senior-sub differential in the low 100s, according to a banker on the deal.
But that is still remarkable, and two trades breaking records in quick succession means there is a clear pattern.
Until now, according to some analysts, the closest a hybrid bond had come to the issuer's senior debt was 80bp for Euroclear's sub-benchmark deal in 2021 (see table).
The bullish pricing is great news for borrowers, but a warning sign, too.
For much of the past decade, hybrid deals have tended to come at around 150bp to 200bp over the issuer's senior debt, in good market conditions.
When the European Central Bank started cutting rates again in June 2024, demand shot up for securities with higher yields. All year, money has poured into investment grade bond funds, squeezing spreads tighter.
Investors have had to get more comfortable with differentials around 150bp. Several fund managers have told GlobalCapital they would not be comfortable buying hybrids much lower than 150bp over senior, and certainly not inside 100bp.
Some issuers are now paying now less than half of that.
This is a double-edged sword for issuers. For now, the going is good and borrowers should make the most of investors' seemingly bottomless demand.
But this is clearly bubble pricing. For years, investors considered the extra risk of a hybrid to be worth 150bp-200bp.
Yes, rating agencies have revised their criteria, so some hybrids can for example now have shorter final maturities, or be rated only one notch below senior by Moody's.
But the fundamental risk has not changed because Moody's assesses it differently. Hybrid capital is subordinated debt — actually half equity, if you believe the rating agencies' analysis.
It ranks below senior in bankruptcy, and the expected principal repayment and coupons can be deferred at the issuer's will.
Investors buying these deals should — and probably do — understand that their spreads could widen a long way.
But issuers, too, should remember that when markets get frothy and risk premiums disappear, they tend to come a cropper suddenly when the mood changes — much faster than if they are just plodding along.
Overstretched investors change course abruptly. An issuer could one day find its spreads are way out and its next hybrid looks much more expensive.
Participants should remember that when spreads do things that until recently seemed inconceivable, they tend to self-correct.
A recent example, which will likely be repeated as soon as next week if France’s government collapses, is French corporate bonds trading through OATs.
Applying any logic to the situation would quickly tell an onlooker that the chance of the French government defaulting on debt is lower than Sanofi or L’Oréal doing so. Yet both were deemed safer by investors for a brief period at the start of this year.
Technicals often trump logic. But at the extreme edges, such as corporates trading inside their home sovereigns or deeply subordinated debt being printed within spitting distance of senior debt, logic tends to win out — sooner rather than later.