In our annual Rodney Blog last week we highlighted corporate hybrids as a potential source of relative value heading into 2021.
As the economy recovers and the outlook brightens, selectively rotating out of senior unsecured debt into corporate hybrids is one proactive way to embrace a more pro-cyclical approach for a post-recession phase of the cycle, particularly for those European corporate issuers that carry a senior investment grade rating. The premium that we see on hybrids in our view more than offsets the additional structural risk of the hybrid optionality, though we do appreciate that the two-notch rating differential to the senior bonds does limit the depth of the investor base.
Judging relative value in hybrids against senior unsecured bonds can be as much of an art as it is an exact science, but for investors this is simplified given the credit metrics are identical and the duration sensitivity is also comparable. It is when investors look at the spread multiple that the comparison becomes interesting i.e. how much more spread bondholders are paid for going down the capital structure. Back in October, we noted hybrid spreads were looking increasingly attractive as senior unsecured spreads were rallying faster.
As we are nearing the end of 2020 and assessing pockets of potential value going into 2021, we have to question the strong rally we have just experienced and assess the attractiveness of the hybrid spread multiple and whether or not we can expect further compression.
Using Volkswagen as an example, it has a senior rating of BBB+ while its hybrid bonds are rated BBB-, which is the typical differentiation. Before the pandemic (as of February 20) Volkswagen’s senior unsecured 2.25% 2027 bonds were trading at a spread of 136bp over government bonds, while its hybrid bonds, the VW 3.875% notes with a June 2027 call, were trading at a spread of 303bp, an equivalent spread multiple of 2.2x.
Following the March sell-off the seniors widened to 347bp, while the hybrids peaked at 788bp, representing a multiple of 2.3x (i.e. very similar to pre-pandemic). Since then, markets have continuously rallied, but while the senior bonds are currently trading at 120bp, the hybrids have lagged and are trading at 326bp, a multiple of 2.7x. The valuation of Volkswagen has recovered quickly, but the senior-hybrid premium has widened.
This lag in corporate hybrid spreads during the recovery – which we see across multiple issuers in the hybrid universe – has created a potential opportunity that is likely to close over the near term as investors continue their search for yield.