Hybrid bonds pose a dilemma for borrowers and bond investors

European companies face a dilemma over their hybrid bonds, as exorbitant interest rates make companies reluctant to dive back into the 175 million euro market.

Borrowers are expected to repay around 11 billion euros of these instruments – which are considered partly equity and partly debt by rating agencies – over the next six months. Typically, they would do just that – return money to investors in a process known as a call, then borrow new money to replace it.

In theory, companies can simply leave the debt in the hands of investors. This option has rarely been used by companies, as they hope to retain bond investors.

Companies that decide not to call a hybrid “would certainly annoy investors.” . . and put pressure on the ability of this credit to re-enter the hybrid market in the future,” said James Vokins, investment grade portfolio manager at Aviva Investors.

But in a new era of sky-high interest rates, borrowers may want to avoid issuing new hybrids to avoid paying high yields.

Hybrids allow companies to raise funds without hurting their credit rating or diluting shareholder ownership in the companies. Their flexible nature also means they offer higher yields than normal credit, which is attractive to investors.

They have been regularly used by large utility and telecommunications groups to strengthen their balance sheets without weakening their credit ratings. But they have become popular with other businesses, including in the real estate sector, as low interest rates have encouraged businesses to borrow.

Volkswagen and EDF led the way, with more than 15 billion euros and 13 billion euros of hybrids in circulation each, according to calculations by a European bank.

Companies have issued low-yielding hybrids in recent years, but will struggle to price new hybrids at this level now that higher interest rates have made the cost of borrowing higher.

For this reason, “the good economic decision will be not to renew them [rather than recall them and issue fresh hybrids]said Gordon Shannon, portfolio manager at TwentyFour Asset Management.

The prospect of taking a hit on hybrids is particularly worrying for companies vulnerable to the economic downturn, such as real estate groups. Hybrids at risk of not being called have traded well below face value in recent months.

Decision time for issuers

Aroundtown, a Luxembourg-based real estate company, is being watched closely by investors as its hybrid matures in January.

Oschrie Massatschi, its capital markets director, recently told investors that Aroundtown is “always observing the market situation before making a decision on the treatment of our January hybrids”, indicating that the high borrowing costs associated with the appeal of its hybrids would weigh on the company’s decision. .

But market watchers expect many big borrowers to call their hybrids to keep their investor base on their side. Earlier this month, Spanish utility group Naturgy announced it would call its billion-euro hybrid, due on November 22.

The instrument’s price had fallen to 97.55 cents before the update, but recovered to face value after the news, reassuring investors who had been watching the company closely.

Line chart of €1bn Naturgy convertible bond price showing Naturgy hybrid jumps after call reassures investors

Energy companies that benefited from high oil prices and Volkswagen, which received money from Porsche’s initial IPO, could also choose to buy back their hybrids without reissuing them. The French utility group Engie announced on October 12 that it would buy back a tenth of its hybrid bonds.

Investors will closely watch companies with outstanding hybrids as there is a risk of a “ripple effect”, where one or more companies deciding not to call the hybrids could pave the way for others to follow suit. the step, said Aviva’s Vokins.

This would leave investors suffering losses and end up with an unwanted asset.

Alberto Gallo, co-founder of Andromeda Capital Management, said “many bond structures” are negative for investors right now. “Low Coupon Hybrids and [convertible bank bonds] sold in recent years are the worst, potentially leaving investors with [an asset] return below inflation,” he added.

Robert D. Coleman