Corporate hybrid instruments have distinctive features, most notably the issuer’s ability to choose not to call the bond at its first call date and to defer coupon payments without triggering a default. In return for these features, investors are rewarded with wider spreads than they would get from the same issuer’s senior bonds.
In general, the way hybrids are structured, the economic incentives and the issuer’s potential reputational damage have made extensions beyond the first call date very rare, especially among investment grade issuers. As such, most investors assess the risks to be low as long as senior spreads remain narrower than a hybrid’s reset level, and as long as the issuer remains strategically committed to maintaining hybrids in its capital structure and secure in its investment grade rating through the cycle.
In most cases, when combined with deep fundamental credit analysis, we agree this is enough. But exceptions do exist, and they can be negative for investors. In this paper, we outline a framework that we believe can help investors avoid this tail risk, by revealing telltale signs of hidden extension risk waiting to be realized when times get tough.
Executive Summary
- We cannot emphasize enough how much we believe bottom-up credit research matters in corporate hybrids, given the asymmetry of downside risk and upside return potential that is associated with subordination.
- While the track record of this asset class shows that, regardless of the economics, extension risk is structurally low once a corporate hybrid instrument loses its equity content, the main driver of spreads remains fluctuations in market pricing of extension risk.
- Investors tend to assess extension risk based on how the hybrid structure interacts with rating-agency policy on equity content, issuers’ economic incentives at first call date, and reputational implications for the business should they exercise the optionality embedded in the security, as outlined in our simplified decision tree below.
- For efficient tail-risk management of extension risk through the cycle, we believe prudent investors should also consider two accounting factors:
– The “Balance Sheet Factor”—Sustainability of the equity structure: The equity structure can profoundly affect corporate strategy decisions. A weak equity structure, characterized by a disproportionate amount of equity being attributable to stakeholders other than the ultimate owners of a business, creates, in times of stress, an incentive to utilize the equity-like features embedded in the hybrid, including the ability to extend. We believe this risk is raised further when hybrid equity is a disproportionately large share of the equity layer, resulting in higher financial leverage.
– The “Cash Flow Factor”—Proportion of cash flow consumed by hybrid coupon payments: The quality of cash flows, their sources and uses can also impact corporate decisions. We identify thresholds over which the ratio of hybrid coupon payments to “Adjusted Funds From Operations” (Adjusted FFO) becomes a cause for concern. Any deterioration in underlying credit fundamentals is amplified by the debt-like feature of hybrid coupons, which create higher operating leverage, and that could tempt the issuer to save cash by utilizing the hybrid’s deferral mechanism. - Our analysis indicates that caution is warranted whenever one or more of the following is true:
– More than 25% of an issuer’s consolidated equity is not attributable to common shareholders.
– More than 15% of an issuer’s consolidated equity is attributable to hybrid capital.
– More than 5% of Adjusted FFO is consumed by hybrid coupon payments. - Breaches of these thresholds have been rare among hybrid issuers, and seen only recently among certain stressed parts of the Real Estate sector, but we believe monitoring these fundamental metrics can help reveal potential “hidden” extension and coupon-deferral risks, which may materialize when unforeseen external shocks create credit deterioration.
