Corporate Hybrids: Seeking Refuge In Quality Sectors

By Linus Claesson

We favor quality down the capital structure.

Economic momentum in Europe is increasingly being challenged by (1) frantic rate hikes, (2) the energy shock and (3) policy uncertainty. While the resulting volatile market conditions could result in a few corporate hybrid securities not being called, we believe extension risk is mispriced. Non-call events remain predominantly driven by issuer-specific fundamental considerations. In this respect, today’s valuations suggest growing and, in our view, excessive fundamental concerns at the issuer level.

The optionality embedded in a corporate hybrid (the ability to extend maturity beyond the first-call date and defer coupons without triggering default) is unlikely to be exercised as long as (1) the issuing entity remains investment grade-rated over the cycle, (2) management and shareholders are committed to preserving investment-grade status, and (3) the hybrids are considered structurally important to the issuer’s long-term funding strategy.

In this context, hybrid investing must be highly selective in a flight to safety environment. As such, we favor:

• Integrated utilities with a strong bias toward the electricity value chain. These names are getting offsetting earnings in merchant-exposed activities and are set to benefit from structural power market reform. Notably, we see scope for power generation re-regulation across Europe and the U.K. as a direct consequence of the energy crisis – meaning higher debt capacity and lower business risk for the sector.
• European oil majors. The high commodity price environment is allowing the sector to generate outsized profits. With prices well above corporate breakeven levels, companies are generating significant free cash flows and have quickly restored balance sheets to pre-downturn levels.
• The telecom sector, given its strong pricing power and relatively low-price elasticity amid rising demand for high-quality fixed and wireless networks. Notably, the sector is dominated by large well-capitalized operators with high margins and free cash generation.

In contrast, we are generally cutting our exposure to the auto sector. Pricing dynamics are set to reverse as supply chain constraints ease. The drop-through to earnings from weaker prices is likely to more than offset favorable pent-up demand dynamics after years of undersupply.

Specifically, we intend to remain extremely selective in the security selection process. While dispersion between sectors and single names is logically set to increase, we prefer intermediate-call hybrids issued by defensive, recession-resistant issuers with limited hybrid refinancing needs. We also favor high versus low back-end instruments for added extension protection.

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