At a time when developed market government bond yields are close to zero, or negative in some cases, and companies are cutting or cancelling their dividends, there is much to be said for asset classes which offer a healthy and stable yield. 
Hybrid capital does just this – and we believe it will become an attractive home for income-seeking investors who are looking to ride out the storm created by the Covid-19 pandemic.
This type of debt-like instrument offers a higher yield than traditional investment grade and government bonds, and greater certainty of income in comparison to equities. Sat between traditional senior corporate debt and common equity, hybrid capital is typically issued by insurance companies, banks and non-financial corporates (which tend to be well-capitalised household names). It is issued in perpetual format, usually with non-call periods between five and 10 years, offering coupons which are tax-deductible.
The Brexit effect
The good news is there are plenty of opportunities in the hybrid capital market for investors who are willing to do their homework. In particular, the sterling market looks cheap because of the uncertainty that has been created by Brexit and the growing possibility that the UK could leave the EU at the end of the year without a deal.
On a like-for-like basis, the sterling hybrid capital market offers value and attractive yields – particularly in comparison to the euro market. For example, energy supplier EDF recently came to the market with a euro-denominated hybrid issue which yields 0.5 per cent to 1 per cent less per annum than its sterling equivalent.
If you think the UK market looks cheap in general, the sterling subordinated financials sub-sector (which includes additional Tier-1 bonds) looks even cheaper. Yields are high in this sector, reflecting an aversion amongst investors towards financials. This may be down to the financial crisis in 2008 not feeling too distant for some investors, particularly in the wake of the sharp market sell-off in March of this year. However, we believe there are selective opportunities in this space.
What’s more, there appears to be a degree of regulatory support for the additional Tier-1 (AT1) or contingent convertible bond (CoCo) market right now. While European regulators have mandated for banks and insurers to suspend share buybacks and dividend payments, these companies are still allowed to pay their AT1 coupons. It’s also worth noting that the suspension of share buybacks and dividends is good news for bond holders from a risk perspective because capital is retained.
We are also fortunate that we have the flexibility to tap into opportunities outside the sterling market, as our portfolios are multi-currency.
Of course, with opportunity comes risk; as we saw in March, the hybrid capital market isn’t immune to volatility. Nevertheless, we were pleased that corporate bond and hybrid capital funds continued to trade and function.
In addition, we continue to monitor extension risk closely. We spend a lot of time analysing the terms and conditions of every issue, as well as the credit risk of any institution. It is important to plan for every scenario that could arise, particularly in the world we find ourselves in today.
Hybrid capital vs traditional asset classes
How does hybrid capital compare to traditional asset classes? Developed market government bonds are a good starting point. Here, yields are close to zero or negative in some cases out to long durations. For example, 10-year gilts were yielding 0.25 per cent at the time of writing, while the five-year gilt yield stood at -0.07 per cent.
Yields on offer from sterling investment-grade corporate bond yields are similarly disappointing. For example, some of the short duration investment-grade corporate bond exchange-traded funds (ETFs) are yielding around 1.5 per cent, which leaves the investor with very little after fees.
At the moment, for comparable risk, the hybrid capital market is able to match or provide slightly higher yields than the traditional high yield market. However, I believe investors are not exposed to a negative event or default risk in the same way. This is because the companies we hold will raise equity capital to shore up their balance sheet before they ask bond holders to burden-share or to do writedowns. This is a nice difference between the hybrid and high yield markets.
In an economically challenged environment, equity holders are grappling with dividend cuts and suspensions, as well as share price volatility. In contrast, I believe that hybrid capital has the potential to deliver a higher income than UK equity income funds with a higher degree of certainty and lower risk over the next 12 months. For example, it is challenging to own shares in banks and insurance companies right now, but this is not the case for hybrids.
Hybrid capital offers less downside risk than equities during an economic crisis. It is lower risk and comes with a higher certainty of income – and depending on how much risk you are comfortable taking, hybrids can provide a yield that is 1 per cent to 5 per cent higher than normal corporate bonds. What’s more, we buy large household names which can continue to service their debt during an economic slowdown – something that can’t be said for some of the high yield names.
For these reasons, we believe the time is ripe for investors to consider an allocation to hybrid capital – a market which has the potential to deliver a healthy income at a time when traditional asset classes are falling short.
Peter Doherty is head of fixed income at Sanlam Investments. The views expressed above are his own and should not be taken as investment advice.