The hidden gem in today’s bond market?

There has been a strong emphasis on the opportunities within (subordinated) financials this year. While maintaining a constructive outlook on this segment of the global credit market, investors may also find an attractive, high-quality yield opportunity in another area: the corporate hybrid market.

So, what are hybrids, how do they function and are they the answer for those looking to strike the balance between yield and risk to optimize returns?

Corporate hybrids are subordinated bonds issued primarily by investment grade companies. They offer a higher yield and credit spreads for investors relative to senior corporate bonds and are typically shorter in duration, often called after five years.

A corporate hybrid is a form of subordinated debt that sits below senior bonds in the capital structure. This means that in the event of financial distress, hybrid bondholders are paid after senior bondholders but before shareholders. To compensate for the added risk, hybrid bonds typically offer higher yields. However, in practice, companies issuing hybrid debt are rarely at financial risk, as these are usually large, high-quality firms, mainly in the utilities and telecommunications sectors. These companies are less exposed to credit or macroeconomic cycles compared to high yield companies, which often operate in more cyclical sectors. Hybrid issuers are less impacted by market fluctuations, have low default risk and maintain steady consumer demand.

They are called 'hybrids' because they blend features of both debt and equity. These characteristics include the ability to defer coupon payments and the absence of a set maturity date or longer final maturities. However, unlike contingent convertible (CoCo) debt issued by banks, deferred coupons on hybrids accrue interest and must eventually be paid. With corporate hybrids, no regulator can block coupon payments, prevent the issuer from calling the bonds, convert them into equity, or write them down.

Hybrid bonds may seem like long-term investments because in theory they can have 30-year, 60-year, or even perpetual maturities with no fixed end date. In practice they don’t last that long. Most hybrid bonds are repaid or ‘called’ by the issuer at their first opportunity, typically after five to ten years. The somewhat predictable call dates give investors a clearer idea of when they can exit. If the bonds are not called, investors continue to earn higher interest, though extension risk has remained low throughout the cycle.

In the current uncertain macro environment, moving up in quality away from high yield and into corporate hybrids makes sense, especially given expensive valuations and the minimal yield sacrifice. With market consensus pricing in a soft landing, reflected in compressed high-yield credit spreads, corporate hybrids offer a chance to capture attractive yields while avoiding lower-quality market segments most exposed to tail risks. In a market with little room for error, hybrids provide a higher-quality alternative.

When it comes to income, investment-grade credit yields are above 4%, while corporate hybrid yields range from 4% to 8%, depending on factors such as currency, call date, and other structural or fundamental considerations. In the current uncertain macro environment, marked by fluctuating interest rates, corporate hybrids present an attractive investment opportunity relative to other bond types, including high yield. The current yield premium of high yield over corporate hybrids is near historical lows, enhancing the appeal of hybrids on a risk-adjusted return basis.