Hybrid society - Higher yields should not blind investors to the potential risks of hybrid bonds
In response to strong investor demand, businesses across a range of sectors are increasingly turning to so-called ‘hybrid’ bonds as a way of raising capital, but are the potential attractions as clear-cut for investors as they are for the companies issuing them? While there would at first glance certainly appear to be some enticing headline yields on offer from these financial instruments, investors do need to be aware of the added risks that can accompany them.
As the name would suggest, hybrid bonds sit, like preference shares, somewhere on the spectrum between ‘proper’ equity and secured senior debt – what we might for the sake of clarity here call ‘full’ bonds. However hybrids sit a little more towards the debt end of the spectrum than preference shares, for example the interest payments on hybrids enjoy tax benefits just as those on full bonds do.
The real attraction of hybrid bonds for companies relates to credit ratings because, when assessing a business’s creditworthiness, ratings agencies will treat a certain percentage of any hybrid as equity rather than as debt, which full debt investors see as a positive. Hybrid bonds therefore help a company with its credit rating while at the same time not upsetting existing shareholders by diluting their positions with new share issues.
Good news, at least in theory, for companies then but what about investors? As we have seen, hybrid bonds are not senior debt so their holders inevitably give away a lot of the protections enjoyed by investors in full bonds. If a company does not pay interest on a full bond, for example, that will typically be seen as an act of default, and bondholders then have various powers to try and ensure they get their money.
Hybrid bondholders are not so blessed – indeed, it is one of the necessary conditions for ratings agencies to class these instruments as ‘just enough like equity’, as it were, that they enable the issuing company, as with dividends, to defer paying the coupon at their option.
Furthermore, holders of full bonds would also expect a number of covenants to be in place to control the way the issuing company behaved – for example to restrict its ability to issue extra debt that would rank ahead of their own in the pecking order. Again, hybrid bondholders have few such protections, meaning the company could easily issue more debt that ranks senior to theirs and so lead to less cash being available to pay their own coupons.
Those are a few significant reasons why hybrid bonds are inferior to full bonds but they also lack some of the attractions of equities – for example, hybrid bonds do not enable their holders to vote at general meetings, nor do they offer exposure to any upside in the growth of the business.
Even so, with more traditional income investments currently yielding far less than they have in the past, the yields available from hybrid bonds have proved attractive to the bond markets. For example, the hybrid bonds that have formed part of the refinancing of Dutch telecom KPN we discussed in Bottom line pay above 6% whereas the more secure debt on offer from the company pays around half of that.
The danger is that, with many investors currently so hungry for income, they will see the headline yields on offer from the hybrid bond market and not think hard enough about what they might be giving up in order to obtain them. If, for example, they find themselves a decade from now wondering what happened to that attractive coupon they used to enjoy but which has been deferred for the previous five years, they might then reflect on why they were so hungry to obtain that yield. Might they not have been better off with good old-fashioned debt or equity, which has served the world so well for hundreds of years?
None of this to suggest there is anything intrinsically bad about hybrid bonds. As ever though, investors do need to appreciate the differences and the risks before they buy because, if you reach for higher yield without fully understanding the sacrifices or risks involved to obtain it, you can lay yourself open to serious disappointments.
As a final point, from the perspective of old fashioned equity investors like us, the verdict of the ratings agencies on how much hybrids are like debt or like equity is irrelevant. These instruments rank above shareholders in the pecking order and so have to be treated 100% like debt.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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