The Corporate Hybrid Market Passes The Test

By Linus Claesson

The extension risk premium should compress as investors gain clarity on corporate behavior throughout the credit cycle.

The corporate hybrid market had a trying year in 2022, which marked an important test for extension risk and how the asset class functions throughout the more challenging part of the credit cycle. We believe the asset class passed with flying colors.

Corporate hybrids tend to exhibit high beta relative to non-subordinated credit, resulting in challenging absolute returns during bear markets. On the plus side, investors often learn a lot during difficult years. Here are some key lessons from 2022:

• Lesson One: Core hybrid-issuing sectors will make all reasonable efforts to call their hybrids at the first call date, to preserve the securities’ equity content, avoid tarnishing their reputations and ensure long-term capital market access on favorable terms. All hybrids reaching their first call date were called last year, with one exception (Aroundtown).
• Lesson Two: Aroundtown’s (OTCPK:AANNF, ATWNY) costly misstep of extending beyond the first call date serves as a stark reminder for other issuers that a non-call decision can substantially impact their weighted-average cost of capital. The market’s reaction to this situation is likely to strongly discourage other hybrid issuers from considering a non-call.
• Lesson Three: A rigorous bottom-up approach to selecting single names is the best way to add value in this asset class. We favor issuers (1) that are likely to remain investment-grade rated over the cycle; (2) where senior spread levels are likely to remain inside the reset over the life of their hybrid; and (3) that have a strong commitment and incentive to maintain hybrids as a strategic part of their capital structures.

We believe investors’ understanding of extension risk has improved over the past year, and consequently, that the hybrid-specific risk premium should compress. Furthermore, in the year ahead, the hybrid market is set to benefit from a number of factors, including:

• A favorable technical backdrop. We see strong demand for high-carry product amid projected issuance of some €20 billion in 2023. Primary supply in 2022 and 2023 combined is unlikely to reach historically “normal” volumes of about €40 billion issuance per annum.
• A flight-to-safety environment. The issuers and sectors represented in the corporate hybrid universe are generally robust and well-positioned to operate in both inflationary and recessionary environments.
• Attractive valuations. We believe all-in yields are as attractive as we’ve seen in the history of the asset class.

In a nutshell, we view the short-duration and high-quality nature of corporate hybrids as particularly attractive characteristics given hawkish central banks and the weakening macro environment.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. The firm, its employees and advisory accounts may hold positions of any companies discussed. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC. © 2009-2023 Neuberger Berman Group LLC. All rights reserved.

Click to enlarge

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.