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Buysiders contemplate hybrid rotation following AT1 fallout

Investors are considering whether the fallout from the writing off of Credit Suisse’s Additional Tier 1 (AT1s) bonds earlier this month could provide a positive tailwind for corporate hybrid debt if buysiders rotate out of bank loss absorbing paper and into subordinated corporate issuance, given that the instrument provides greater yield than investment-grade senior paper and there is no risk of the regulator-mandated writing down of these bonds.

Some managers are now questioning the value of AT1s in the light of the Swiss regulator’s decision to completely wipe out the value of more than USD 17bn of CS’s subordinated debt while equity holders were awarded a payout.

“I really doubt how or if AT1s and other subordinated bank debt will recover from this,” said one buysider, who added that he was avoiding the asset class and was seeing a lot of other investors exiting positions.

Although other market participants are more optimistic about the future of the asset class, they nonetheless acknowledge the wider impact that the zeroing of CS’s AT1s had on the market. While noting that the most affected instruments have been those of more peripheral banks from countries such as Spain, Italy and Ireland, core European names were also tainted.

Deutsche Bank has obviously come under pressure, but people are also worried about Societe Generale and Commerzbank,” said a second buysider. “That’s basically because they may face the same pressures as CS with regard to fast money or deposits flowing out quickly.”

Spanish lender Banco de Sabadell’s EUR 500m 5.625% perpetual non-call March 2026 AT1 is now showing at a 74.2-mid, according to Markit. On 17 March, the bond was quoted at 82.2. A Societe Generale USD 1bn 4.75% perpetual non-call May 2026 AT1 is now indicated at 72.2-mid. The French bank’s bond was seen at 80 on 17 March.

Hybrid substitute

AT1s, which offer significantly higher yields than bank senior bonds, grew in popularity among investors over the past decade as interest rates plummeted. Instead of capturing higher yields by going down in credit quality, yield-starved investors could take subordination risk by buying AT1s from bank names which, at an issuer level, held investment-grade ratings.

Now, with the value and future of AT1s being called into question and many funds needing to produce higher returns than are available through investing in much of the senior universe, investors are weighing the relative value of corporate hybrid debt.

“I see a rotation into corporate hybrids from AT1s,” said Andrea Seminara, CEO and chief investment officer at the fund manager Redhedge. “For anyone in these types of funds targeting a certain amount of yield and duration, you are not going to buy senior because the yield is not enough.”

Corporate hybrids are subordinated bonds which typically receive 50% equity and 50% debt treatment from the ratings agencies. The securities are often ranked two notches below a company’s senior unsecured bond rating to reflect both these debt and equity characteristics.

“We’ve actually already seen more buyers coming into hybrids since what has happened at CS,” Seminara said. “I don’t know if it is an actual rotation. I don’t know if they are selling financials, but definitely there is more confidence in buying corporate hybrids. And it’s a much bigger sector than AT1s.”

The product’s appeal to a borrower is that the 50% equity treatment helps keep net leverage metrics low and supports an improved overall credit rating for a company. The securities have long or perpetual maturities which provide higher yields to investors to compensate for the potential of a coupon deferral or extension risks where the securities are not called at the first call date.

The majority of borrowers active in the hybrid market hold investment-grade credit ratings at a corporate level. French energy company TotalEnergies (A1/A+/AA-), Spanish energy firm Repsol (Baa1/BBB+/BBB), Dutch telecoms company KPN (Baa3/BBB/BBB) and its Swedish peer Telia (Baa1/BBB+) all have layers of hybrid debt in their capital structures.

A number of real estate credits are also present in the hybrid market; however, because of concerns over the impact of rising interest rates on the industry’s high levels of leverage and the cost of refinancing their hybrid debt, investors are particularly wary of the sector.

“Hybrids from utilities and telecoms are good, but real estate is untouchable, untouchable at any price,” a third buysider said. “I don’t think these bonds will ever be called, not even one or two years.”

If you are able to find hybrids from “solid” Triple-B rated issuers then it makes sense to use them to replace AT1s in a portfolio or to allocate new money, the third buysider added.

Deferrals and extensions

The asset class, however, is not without its risks, and there are potential events that could trigger steep sell-off in the sector akin to what has recently been seen in the AT1 market. The largest risk to the market is that an issuer, under pressure from declining cash flow, exercises its option to defer a coupon payment, a fourth buysider said.

“I think that the hybrid market would react much more violently to that than what we saw the AT1 market do recently,” the fourth buysider added.

There is already some precedent for this. In November 2022, German real estate credit AroundTown announced that it was considering a potential deferment, and although in the end the borrower decided not to defer the payment, the company’s hybrids plummeted in the secondary market.

Although real estate hybrids had been under pressure for some time due to concerns over the impact of rising interest rates on the sector, the cash price of AroundTown’s EUR 600m 3.375% perpetual non-call September 2024 notes fell around five points in the week following the 29 November earnings announcement, which included the management comment concerning the coupon deferral.

All five of AroundTown’s hybrids that are quoted on Markit are now marked at cash prices between 30 and 45-mid, with the lowest yielding instrument offering more than 76%.

Hybrid holders also face extension risk, where instruments may not be called at the first call date, leaving hybrid holders with longer-duration securities. Extension risk also opens up the prospect of downgrades by ratings agencies given instruments are at risk of losing their 50% equity classification if the security is extended past the call date.

But in the current yield environment, whether or not to call a hybrid is a difficult decision.

Given that many outstanding hybrids carry coupons of 2% or 3%, but yield double those figures in the secondary market, the fourth buysider said that it was unlikely these issuers would call and refinance their bonds, even if they risked losing access to the market. “A big risk to the hybrid market is that all it takes is one big issuer to just say ‘we won’t call it’,” continued the fourth buysider.

Despite these risks, hybrids typically offer a lower yield than AT1s. An investor considering a move out of AT1s into corporate hybrids would have to be willing to accept tighter pricing, the second buysider said.

“My view is that most likely it makes more sense for people to stay with banks but move into Tier 2 bonds or even into seniors as bank yields are still relatively attractive for the rating,” the second buysider said. “There are a lot of people that like banks and won’t want to exit the sector altogether.”

Although Tier 2 bonds are a form of bank loss absorbing capital, they are senior to AT1s.

But another factor to be considered by asset managers is how they justify their choices to their clients. Being underweight financials and potentially missing out on some upside should the sector rally is, potentially, a more comfortable position to justify than going long and getting caught out if the crisis persists.

“No one wants to be a hero and take the opposite side of the financials trade,” Seminara said.