The high yields might look attractive but are hybrid bonds all they are cracked up to be? Andrew Lyddon, UK equities manager at Schroders, takes a look.
In response to strong investor demand, businesses across a range of sectors are increasingly turning to so-called ‘hybrid’ bonds as a way of raising capital. But are the potential attractions as clear-cut for investors as they are for the companies issuing them?
While there would, at first glance, certainly appear to be some enticing headline yields on offer from these financial instruments, investors do need to be aware of the added risks that can accompany them.
As the name would suggest, hybrid bonds sit, like preference shares, somewhere on the spectrum between ‘proper’ equity and secured senior debt – what we might, for the sake of clarity here, call ‘full’ bonds.
Schroders' Andrew Lyddon wonders whether hybrid bonds are all they're cracked up to be
However, hybrids sit a little more towards the debt end of the spectrum than preference shares. For example, the interest payments on hybrids enjoy tax benefits just as those on full bonds do.
The good and the bad
The real attraction of hybrid bonds for companies relates to credit ratings because, when assessing a business’ creditworthiness, ratings agencies will treat a certain percentage of any hybrid as equity rather than as debt, which full debt investors see as a positive.
Hybrid bonds, therefore, help a company with its credit rating while, at the same time, not upsetting existing shareholders by diluting their positions with new share issues.
Good news, at least in theory, for companies then. But what about investors?
As we have seen, hybrid bonds are not senior debt so their holders inevitably give away a lot of the protections enjoyed by investors in full bonds.
If a company does not pay interest on a full bond, for example, that will typically be seen as an act of default, and bondholders then have various powers to try and ensure they get their money.
Hybrid bondholders are not so blessed – indeed, it is one of the necessary conditions for ratings agencies to class these instruments as ‘just enough like equity’, as it were, that they enable the issuing company, as with dividends, to defer paying the coupon at their option.
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