What are corporate hybrids?
Corporate hybrids are a type of bond issued by companies – they are known as hybrids because they combine certain features of debt and equity.
Like ordinary corporate bonds, corporate hybrids pay regular coupons and can be called by the issuer. But like equity, they effectively have no maturity date and issuers can pause coupon payments in the same way they can with dividends.
For issuers, corporate hybrids can be a useful financing option because favourable treatment from rating agencies means they can issue more debt without negatively impacting their overall credit rating.
For investors, corporate hybrids can be attractive assets as they are typically issued by robust investment grade companies but pay much higher yields than regular corporate bonds.
Where do corporate hybrids sit in a company’s capital structure?
Companies issue a mix of debt and equity as they look to fund their operations as cheaply as possible.
When it comes to bonds there are a range of options, each with different characteristics and presenting investors with different levels of risk.
Investors will naturally demand lower yields on bonds deemed to be less risky – i.e. those that provide the greatest certainty of coupon payment and the lowest chance of losses in the case of default.
Senior secured bonds sit at the top of this capital structure, because they are first in line for repayment and come with a claim on some of the company’s physical assets. Equity sits at the bottom, because shareholders are last in line to get their money back if the company runs into trouble and dividends are discretionary.
Corporate hybrids, with their combination of debt and equity features, sit somewhere in the middle. Companies typically have to pay around two-to-three times more for hybrids than they do for senior unsecured bonds.
Why do companies issue corporate hybrids?
For companies seeking capital to invest in new infrastructure or to make an acquisition, bonds are typically cheaper to issue than equity. However, more debt also means higher leverage, which could result in a downgrade of the firm’s overall credit rating.
However, because they are subordinated and their coupons are deferrable, rating agencies give hybrids 50% “equity credit”; a €1bn hybrid is treated as if the company has just raised €500m of debt and €500m of equity.
The example below shows the options available to a BBB rated company with £3bn of debt on £1bn of earnings (leverage of 3x) and a downgrade trigger at 3.5x leverage.
Corporate hybrids thus enable firms to raise capital with a lesser impact on leverage, protecting their credit rating. For companies rated BBB and above, corporate hybrids can help to preserve their much-prized investment grade status, which if lost would mean higher borrowing costs going forward.
Corporate hybrids are a popular financing tool for investment grade companies with stable and predictable revenue streams but high capital expenditure requirements, such as utilities and telecoms firms.
What is corporate hybrid extension risk?
Rather than a maturity date, corporate hybrids have a “non-call” period, typically of between five and eight years. At the end of that period, investors generally expect the issuer to call the bond (returning capital to investors) and issue a replacement.
However, the issuer can choose not to call. Among investors, the likelihood of a corporate hybrid not being called is often referred to as “extension risk” – the bonds remain outstanding with their coupon reset to a slightly higher level pre-determined by the bond documentation.
While issuers are under no obligation to call, they are incentivised to do so because rating agencies’ rules for hybrids are designed to ensure these securities remain a permanent part of the issuing company’s capital structure.
If a hybrid is not called, the issuer loses the 50% equity treatment on that bond – meaning it becomes 100% debt. This impacts leverage and could trigger a rating downgrade for the company.
In addition, if a hybrid is called but not refinanced with a new bond, the issuer loses the equity treatment on all of its outstanding hybrids. Clearly this is an outcome issuers are heavily incentivised to avoid given its impact on leverage, and the incentive is even greater for firms with a large stack of outstanding hybrids.
What influences a corporate hybrid issuer’s decision to call?
When a corporate hybrid is approaching the end of its non-call period, if market conditions allow the issuer to sell a new hybrid at a similar cost, then it is an easy decision to call and replace.
However, if market conditions (or investor perceptions of the company) have worsened and the coupon on a new hybrid will be significantly higher than the stepped-up coupon on the non-called hybrid, then the issuer may be influenced by other factors:
1) Would losing equity treatment on the hybrid impact the issuer’s rating?
If the leverage impact of not calling the bond would likely trigger a downgrade, then the issuer is heavily incentivised to call and replace.
2) How much does the issuer rely on hybrid debt?
If hybrids represent a sizeable percentage of a company’s total debt stack, then not calling one hybrid will likely make issuing future hybrids more expensive, since bondholders demand a premium from issuers with a history of not calling hybrids.
Calling and not replacing is also more damaging the more hybrid debt an issuer has, since losing equity treatment on the entire hybrid stack could have a big impact on the company’s leverage and potentially trigger a downgrade.
Can corporate hybrid issuers afford not to call?
For bondholders trying to anticipate whether a corporate hybrid will be called or not (how much extension risk it has), the crucial point is that the relative cost of calling and issuing a new hybrid cannot be viewed in isolation.
Of equal (or arguably greater) importance is how the decision could impact the issuer’s reputation and its overall cost of funding, both with the corporate hybrid investor base and the capital markets more broadly.
In late 2022, for example, the Spanish telecoms giant Telefonica decided to call and replace a corporate hybrid issued in December 2017. With market conditions having worsened materially over the course of 2022, at 7.125% the coupon on Telefonica’s new deal was far higher than the 5.1% coupon it would have been left paying if it had chosen not to call.
Call example: Telefonica’s 2022 decision
This decision highlighted how corporate hybrid issuers don’t consider their calls in pure bond-by-bond economic terms. As one of the bigger hybrid issuers in Europe with around €7bn outstanding at the time, Telefónica chose to demonstrate its commitment to the asset class and avoid the reputational risk of a non-call.
Since its inception in 2003, the corporate hybrid market has experienced several periods where investors have priced in greater extension risk. However, in large part due to the features and incentives mentioned above, non-calls remain a rare event.
Established hybrid issuers with a proven track record of issuing throughout the cycle, as well as strong financials able to weather higher interest costs when they arise, can typically be expected to call even when the decision appears uneconomic.
While 57% of outstanding corporate hybrids have an investment grade rating, some 98% of the issuers in the market are rated investment grade.
For investors who are comfortable with the structure of corporate hybrids and who do the credit work on the issuers they hold, the higher yields available in the asset class can be very attractive.
Corporate hybrids by numbers
