The search for yield is on at a time when developed market government bond yields are close to zero, or negative, and companies are cutting or cancelling their dividends. 
In this challenging environment, some of the traditional methods in how investors seek extra yield have become less effective or indeed quite simply unavailable. This is why hybrid capital currently offers a number of attractions.
For those seeking exposure to credit, investment grade is typically the first port of call. However, yields across the investment-grade universe continue to disappoint, as the market is overcrowded by investors and central bank buying activity.
In the past, investors might have been tempted by the higher yields on offer from longer-dated bonds, issued by a company they liked. However, as the yield curve has become so flat, investors are not being rewarded in the same way for pushing out duration. The increase in interest rate and inflation sensitivity that duration brings in this reach for yield may be underestimated in the current environment, but it remains a double-edged sword on a macro play.
The next step is to look further down the credit quality scale at high yield. Here, the yields on offer are more attractive – around 4.5 per cent across the European high yield market. However, as Covid-19 continues to make the operating environment more challenging for businesses across a range of sectors, defaults are set to rise. According to rating agency Moody’s, the probability of default stood above 6 per cent across global high yield markets during the third quarter of 2020. Said differently, a 50-security theoretical high yield portfolio would have experienced three default situations of some sort year-to-date. More than ever, investors who are allocating to this segment have to get their credit selection right.
In contrast, investors in hybrid capital are not exposed to negative event or default risk in the same way. Importantly and positively, hybrid capital offers a healthy and sustainable yield of between 2 per cent and 6 per cent, depending on your risk appetite or tolerance. 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 names). The hybrid debt has been developed to meet rating agencies and regulators’ requirements, which have emerged mainly since the financial crisis. As a result, hybrid capital is normally issued in perpetual (or long-dated) format, with a call schedule after five or 10 years, offering coupons which are tax-deductible for the company.
It is an encouraging development that a number of investment-grade companies have issued hybrid capital, offering investors a new risk-reward alternative. After completing the credit research process, and concluding with a positive opinion then the attractive yield available on hybrid capital instruments should offer a very interesting investment opportunity.
The trade-off is that for a more attractive yield, you are giving the company’s management team greater flexibility in relation to their obligations. Notably, if the company is struggling operationally then they have the option to defer the coupon. It is a risk that you take on board as an investor, but you do get an extra reward at the entry point in the form of a higher yield.
A key question for subordinated debt/hybrid capital investors is to achieve a degree of comfort with the business model and management team. If that comfort is forthcoming, then it would and indeed could be appropriate to move down in the capital structure.
It is then a case of selecting the right subordinated debt instrument that suits your risk-return profile. For financials, they range from Additional Tier 1 (AT1) for banks, which includes contingent convertibles (CoCos), and Restricted Tier 1 (RT1) which is the equivalent for insurers. They sit at the higher end of the risk scale and are followed by Tier 2 and Tier 3. There is a spectrum and a number of risk-reward trade-offs to consider at every level.
As investors in this space, we, at Sanlam Investments, conduct in-depth credit analysis on a case-by-case basis. The Investment Team closely examine the prospectus of each issue to decide whether we are comfortable in giving away certain options to the company’s management team. In addition, we ask ourselves if we are comfortable with a perpetual feature and whether the yield available is sufficient.
We focus on large household names which we believe can continue to service their debt during an economic slowdown. We also follow closely the potential risks at all times, not least extension risk, where an issuer may decide not to redeem the debt at the first opportunity scheduled against initial expectations.
It is encouraging to see many examples where investors hold both a company’s senior and hybrid debt. This will ultimately influence a company’s management team to respect the first call date and keep their reputation intact for future issuance.
In addition, it is positive to see the regulatory support in place for AT1s right now. While European regulators have mandated 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 within their businesses. Having said that, if a company becomes insolvent, the same regulator will expect the higher-risk hybrid bondholders to contribute and support the struggling company as a going concern.
With these factors in mind, I believe the time is ripe for investors to consider moving down the capital structure to allocate to hybrid capital – a market which has the potential to deliver a healthy yield at a time when traditional asset classes are falling short.
Guillaume Desqueyroux is a fund manager in the fixed income team at Sanlam Investments. The views expressed above are his own and should not be taken as investment advice.