In previous articles, we have described the differences between “European-style” corporate hybrid securities (the structures with coupons that are “stepped up,” first issued in Europe, but long popular in markets such as Canada and Australia) and “U.S.-style” hybrids (those without coupon step-ups, chiefly issued in the U.S.). The structural incentives for an issuer to call a European-style hybrid at its first call date are very strong, and we believe they almost always override economic incentives not to call. The history of the asset class supports this belief.
Nonetheless, particularly during periods of risk aversion, market participants tend to price European-style hybrids more like U.S.-style hybrids, in line with economic rather than structural call incentives. We believe this offers arbitrage opportunities between hybrids from the same issuer with respectively higher and lower reset spreads. In the first half of this article, we describe this arbitrage opportunity and a framework for taking advantage of it.
In addition, we discuss how extension risk is sometimes priced inconsistently in U.S.-style structures. We introduce a new concept, “Yield to Loss of Equity Content,” to identify arbitrage opportunities in this market.
Executive Summary
- The respective structures of U.S.-style and European-style corporate hybrids lead to three observations regarding extension risk:
- Corporate hybrid portfolio managers can trade not only credit risk, but also structure risks; this paper identifies ways to arbitrage market mispricing of extension risk.
- For European-style Hybrids:
- For U.S.-style Hybrids:
- In other words, we believe an arbitrage is available in European-style hybrids by buying extension risk that is overcompensated at the instrument level because the market tends to price them the same way it does U.S.-style securities; and for U.S.-style hybrids, we identify a different arbitrage by removing the “false” extension risk associated with the first call date alone and focus instead on the date of loss of equity content.
- U.S.-style hybrids should see instrument-specific, economics-based pricing of their extension risk, in line with their reset spreads.
- European-style hybrids should see issuer-specific, fundamentals-based pricing of their extension risk, in line with the deterioration of their creditworthiness.
- All European-style hybrids from the same issuer with a similar effective maturity should be priced as if they carry the same extension risk at any point in time.
- During periods of general risk aversion, many European-style hybrids are priced as though they are U.S.-style hybrids, with lower-reset hybrids trading at relatively wider market spreads than higher-reset-spread hybrids. This discrepancy creates a structural arbitrage opportunity.
- We define the theoretical, fair value credit spread for a lower-reset spread instrument and, based on pricing patterns during risk aversion periods, we suggest going long on an instrument when its excess spread over its theoretical spread exceeds 10% for lower-beta hybrids or 20% for higher-beta hybrids.
- To find arbitrage opportunities, we introduce the concept of “Yield to Loss of Equity Content”: Pricing hybrids to the date at which they lose equity content—which is the main incentive to call and replace them—removes the pure extension risk economics between bonds with different call dates.
- When applying this pricing concept, in some instances we find that the market demands higher compensation for 30NC5 structures (hybrids with a 30-year maturity and a first call date after five years) than for 30NC10s (hybrids with a 30-year maturity and a first call date after 10 years), sometimes even when the 30NC10s have higher reset spreads.
Identifying Extension-risk Arbitrage on a European Issuer’s Hybrids Curve
An illustrative European-style hybrid securities curve, showing a typical case of instruments with relatively low reset spreads trading at higher market spreads
Source: Neuberger Berman. For illustrative purposes only.
