Those who have watched the latest series of Top Gear will be aware that the show features a vociferous debate between Jeremy Clarkson and Richard Hammond as to the relative merits of two new hyper-cars, the McLaren P1 and the Porsche 918 Spyder. Hyper-cars are what you get when you combine supercars with quantitative easing and these two are both examples of the latest plug-in hybrid designs. Plug in hybrids combine a petrol engine with an electric motor. This enables the driver to comply with zero emission regulations whilst cruising around town and then switch to the petrol engine once outside the city limits and benefit from the extended range and 608 bhp the Porsche’s petrol V8 offers. A further feat of engineering allows the driver to use the electric motor to boost the already generous 608bhp by an additional 279hp. It will come as no surprise that the Porsche is the first series production street-legal automobile to complete a sub 7-minute lap of the Nürburgring.
Regrettably for me, invitations to the Top Gear test track have been a bit thin on the ground however I did seize the opportunity to attend the BofAML Corporate Hybrid breakfast earlier last week in London. Whilst the preamble on plug-in hybrid hyper-cars might seem superfluous, in the context of the fixed income hybrid market there are indeed many similarities.
The Review
Corporate hybrid instruments exhibit both credit and equity features. They have developed in response to investors’ desire for instruments offering an attractive yield from well-known and respected corporate balance sheets. At the same time, for the issuer, they can provide financial flexibility, a boost to liquidity and in favourable market can lower the cost of capital. This is achieved in part due to their subordination as well as the ability to defer coupons which allows rating agencies and the IFRS to count them (partially) as equity. As they don’t have voting rights there is no risk of diluting the existing shareholders and as the bonds pay coupons they can offset these against tax, unlike equity dividends.
The News
As with the cars, (all 375 of the £1m McLaren P1s have sold out) demand for these hybrid products has been huge with €30bln of corporate hybrids issued in 2013. Year to date, 2014 issuance already outstrips that from 2012 with close to € 9bln including new issues from Enel, EDF, Orange and ENBW, the German utilities company, who issued earlier this week.
Interestingly whereas the early hybrid deals were partially driven by Private bank demand, Private banks now only make up 8% of the investor base with Fund managers and hedge funds taking down 80% of the 2013/2014 issuance and pension funds and insurance companies owning the balance according to data from BAML.
BofAML have created two new indices specifically focused at Corporate Hybrids with a total market value of US$86bln. The Global IG Hybrid Non-Financial Corps index (GNEC) accounts for 76% of the total market value and the High Yield equivalent (HNEC) accounts for 24%. Both include issues denominated in EUR, GBP as well as USD Eurodollar issues. US Corporates have not yet taken to the corporate hybrid market in the same way as European issuers as in part they are less concerned about supporting their investment grade ratings. Utilities make up over 40% of both indices followed by Telecommunications.
Performance
The GNEC returned +704bps of excess swap return in 2013 with HNEC returning +1,402 bps over swaps. Year to date, the excess swap returns are +91bps and +160bps, slightly underperforming their financial hybrid counterparts, CoCos, whose index has returned an excess return of +170bps. Despite the many differences between Corporate Hybrids and CoCos, managers will have an overall budget for hybrid products and the high demand we have seen for CoCos this year has probably given them the edge.
The indices provide an interesting insight into the common perception - that corporate hybrids are high beta – they are. Since 2007, the IG Global Corp hybrid index has exhibited twice the volatility of the IG Global Corp equivalent however the average monthly excess returns are have also come in at twice those of the IG index so on a risk adjusted basis both indices have similar information ratios. In addition, according to data from Morgan Stanley, over the past 3 years, when compared to High Yield, longer dated credit and bank sub debt, European corporate hybrids have delivered a superior risk adjusted performance.
As with any product that in part benefits from an arbitrage, hybrids are susceptible to changes in the rules. If the corporate hybrid loses its partial equity treatment, as was the case with the Telecom Italia hybrid following its downgrade to sub-investment grade by Moody’s last October, it becomes an expensive source of funding for the issuer.
And on that bombshell…
When surveyed, none of the asset managers at the breakfast indicated any appetite from investors for a fund composed solely of corporate hybrids. However we were all in agreement that corporate hybrids deserve an active allocation in a diversified portfolio. We believe that the strong technicals that have supported the market should continue in 2014 and so long as you have a strong team of analysts who understand the idiosyncrasies of the structures, corporate hybrids will continue to add value to our portfolios.
