Podcast: Subordinated, but certainly not suboptimal

This podcast is for professional investors only.

Erika van der Merwe (EM): What are the yields that you are seeing right now, Daniel?

Daniel Ender (DE): In corporate hybrids we’re seeing yields between 5 and 7% currently, also depending on the currency. But we find corporate hybrids at the moment as an attractive way to indeed pick up yield over investment grade bonds because as Jan Willem also alluded earlier, the probability of default also in corporate hybrids is pretty low.

Welcome to a new episode of the Robeco Podcast.

EM: Markets are preparing for lower rates. Fixed income investors who need their portfolios to keep on generating enough income or having to evaluate their options. And for those who don’t have the stomach for high yield credit assets, the investment grade segment of the credit market has some interesting possibilities. And we’re looking in this show at the subordinated segment of the market with two specialists in this area. They are Daniel Ender and Jan Willem Knoll. Both of them are portfolio managers in the Robeco Credit team. Welcome both. Good to have you here.

Jan Willem Knoll (JWK): Thank you. Erika.

DE: Hi, Erika.

EM: So both of you invest in the subordinated segment of the credit market. So Jan Willem, you in financial debt, and Daniel in corporate debt. Shall we start with a quick explainer on what these respective instruments are? So, Daniel what is a corporate hybrid bond? And where is it on the risk spectrum?

DE: Yeah, a corporate hybrid is a subordinated instrument that is typically issued by high quality issuers with typically an investment grade rating at the issuer level. They are typically issued by companies in the telecommunication and utility sectors or very defensive non-cyclical sectors. Despite them having the appearance of being long duration assets – because they’re a market that has perpetual or 60- or 30-year maturity instruments – [they] are actually not long duration assets in the sense that most of them, the vast majority are called at their first call date, which typically is between five and ten years, from issuance.

EM: So even though it might look like a perpetual instrument, in practice it has a far shorter duration and maturity.

DE: That is correct. And the reason why is that there are structural features that provide a strong incentive for the company to call at the first call date. So those structural features are the loss of equity credit after the first call date in instructors that have a traditional European step structure. So basically they have coupon step-ups of 100 basis points cumulative after 20 years.

EM: Jan Willem, this is where you come in. So AT1 (Additional Tier 1) capital from banks, also called contingent convertible bonds. A lot of terminology here. But what do these instruments do? So issued by banks and insurers, am I right?

JWK: Yeah that’s right. If an insurance company issues an AT1 that’s called an RT1, but maybe best to focus first on banking subordinated debt. So that is debt which is issued by banks to fulfill regulatory capital requirements. So roughly AT1 and Tier 2. So AT1 is the most junior, Tier 2 is slightly less junior. That comprises roughly 25 to 30% of total capital of banks. It’s a pretty large market there, so that’s why we are interested. So that’s 700 billion for AT1 and Tier 2 issued by European banks alone.

And we can talk about risk, we should talk about risk. But just to give you an idea: the issuer quality on average of bank AT1s and Tier 2s is A. So we think actually the default risk is not that high. I can explain further if you allow me but maybe I should first explain AT1 if I may?

So AT1 is the most junior debt, sits just about above equity in the banking balance sheet. They are perpetual instruments. So unlike for corporate hybrids, unlike Tier 2s as well. But they are callable typically after five to seven years. And banks in 95% of all cases do call those instruments. Important: coupons are discretionary. So management teams can decide to switch off the coupon when needed. Normally when a bank is loss-making…

EM: So it’s like a dividend, they could also choose not to pay that out.

JWK: No, the impact of not paying a dividend is way less for a bank than not paying AT1 coupon. So it basically never happens that a bank doesn’t pay its AT1 coupon. It happened once, to be 100% clear, that was Bremer Landesbank. It’s always a German bank of course, who is in trouble in the financial sector.

EM: We’ll let that go.

JWK: So we can ignore this risk. Regulators call this AT1 should have loss absorbency on the going concern basis. So before a bank goes bankrupt, it should already absorb losses, the instruments. So that is an important term to remember. And then AT1s can also, as an AT1 investor you can lose your principal. And of course that happens when a bank is in trouble. And typically when a bank has reached a point of non-viability, the term Daniel used. And that’s basically when a regulator says well the bank is not viable anymore. Deposit holders run away for example. That’s what typically happens. Now that also doesn’t happen a lot. Of course in 2008 it happened in the US a couple of times. In Europe you’ve seen it with Credit Suisse and Popular. Popular was a non-event for the AT1 market because it was a non-systemic relevant bank. Credit Suisse was deemed systemic-relevant, it also had that label, a global significant important institution. So that had a big impact on the market.

EM: So Jan Willem, you said that the market in AT1 is about 700 billion.

JWK: No, that’s AT1 and Tier 2. AT1 is roughly 250 billion. Tier 2 you add another 400. And if I would add insurance Tier 2 and RT1 (the insurance type of AT1), we get close to a trillion.

EM: That’s sizable.

JWK: Issued by European institutions alone.

EM: Daniel what’s the scope of the corporate hybrid bond market?

DE: Yeah, the corporate hybrid bond market is still pretty niche. So if we look at benchmark-sized non-financial corporate hybrid, so basically excluding real estate and insurance, you’re looking at a total of EUR 250 billion equivalent. That is split between around 150 billion euro denominated hybrid. So that’s predominantly a European asset class. And there’s an additional EUR 90 billion equivalent of US dollar denominated debt. The remainder is a very small fragment, which is approximately 11 billion, which is in the sterling market. So a very small market.

EM: Small but liquid. How tradable is that market?

DE: All three markets – it’s interesting. The liquidity of corporate hybrids has improved over time. So currently if I would have to rank the liquidity, I would place it somewhere between senior secured bonds and high yield debt. So on average, you see beta spreads that hover somewhere in the middle between those two asset classes and between the different currencies, I would say that European corporate hybrids are the most liquid.

EM: So substantial enough for you, Daniel, to run an entire portfolio consisting only of corporate hybrids.

DE: That is correct. So we manage a corporate hybrid dedicated strategy and the investable universe that is out there, which is also growing, enables us to rotate in and out of opportunities.

EM: And what I recently discovered – didn’t know – that they’re also green bonds within the corporate hybrid space. So with the sustainability profile.

DE: That is correct. There’s green bonds issued in corporate hybrid format. And there’s also social bonds as well. So one example is Électricité de France (EDF), the utility owned by the French state. They issued last week green hybrids. But they also had from previous issuance social hybrids outstanding.

EM: Right. And Jan Willem, the same on the financial side: also sustainability profile instruments issued there?

JWK: Yes, especially in the Tier 2 market. And as you know we look at of course sustainable instruments but also at the sustainability of companies. When we look at banks, we also look at governance for example, [which] actually helped us a lot in looking at Credit Suisse. We thought a risk governance to corporate governance of that bank. Also Banco Popular, the other bank which went bankrupt and rolled down AT1s. We also didn’t buy partly for corporate governance reasons. So it’s the instruments, but also the companies. We think ESG considerations are really important.

EM: So taking a step back then, why would investors hold these subordinated instruments, whether they’re on the financial side or on the corporate side, Daniel? So presumably there’s an aspect of diversification because they behave a bit differently. But what about on the income side, which is the preface for this discussion. So right now I understand investment grade credit yields are above 4%, which is well above the 10- to 15-year median. So what are the yields that you’re seeing right now, Daniel, in corporate hybrids?

DE: In corporate hybrids we’re seeing yields between 5 and 7% currently, also depending on the currency. But we find corporate hybrids at the moment as an attractive way to indeed pick up yield over investment grade bonds because as Jan Willem also alluded [to] earlier, the probability of default also in corporate hybrids is pretty low. Corporate hybrids are typically issued by companies that have investment grade ratings, just like in the case of banks and the issuer rating. And in some occasions the instrument rating might be high, BB, but in the vast majority of cases, the issuer rating is investment grade. And as a result, the probability of default is relatively low.

EM: So an investment grade institution company that issues these corporate hybrids, which typically the instrument itself has a lower rating from a rating agency.

DE: Yes. Correct. So on average, S&P and Moody’s rate the corporate hybrids issued by these companies two notches below the senior secured rating, which happens to also be the issuer rating.

EM: Right. Jan Willem, how do you see the yield or the attractiveness of AT1s?

JWK: I’m glad you asked the question, Erika, because we talked about risks but the returns are very important. So the risks are there, but they are limited in our view also. That has to do with bank fundamentals, which are very strong. But indeed, if you look at AT1s, they stay on average have a credit spread of 400 basis points. And then it’s good to know that 40% of AT1s (so the most risky instruments) are actually investment grade rated, so the instrument itself. And 400 basis points compares very well to let’s say, high yield. So high yield might be in dollars maybe 330, 340 basis points…

EM: …over government bonds

JWK: ...over government bonds. In high yield, that contains a lot of what we call ‘phantom yield’. So, yield which is promised we’ll never get it because the companies go bankrupt. I think it’s better to compare it to BBs. So BBs, you might actually get maybe 250. So on AT1 for similar risk 400. So you get very, very well rewarded in our view for the perceived high risk and there is high volatility, there has been high volatility in AT1s, so there have been three big moments of significant drawdowns in AT1s. But the market typically recovers very quickly from that.

EM: Okay. So on that point then Jan Willem, you’ve both referred to the Credit Suisse event. Do you think that has damaged the perception of AT1? I mean, I understand Australia is looking at phasing these out as an instrument and replacing it with something that they consider to be cheaper and more reliable, to quote them.

JWK: No, I don’t think so. I don’t think that – the market was in shock, right? When the Credit Swiss write-down happened. The reason for that was it was a global significant institution. So when that goes belly up, it has potentially a systemic impact on the market. Luckily, the Swiss regulators stepped in. So what they did, they wrote down the AT1s, that was needed to create a capital to be able to sell the bank to UBS for CHF 3 billion. What the market didn’t like, apart from the shock effect of the big bank going bankrupt, was that AT1 holders got zero, equity holders got a small, well, let’s call it a small present.

For us that was irrelevant because AT1s did what they are supposed to do: protect senior bondholders. So technically Credit Suisse did not go into resolution. So it didn’t technically go bankrupt. It was – the AT1s were written down before the event of default and that created a capital to sell the bank to UBS. So there’s a slight difference but if you would have a resolution, so a bail-in, you would have built in senior debt and that would have been a much bigger market event.

If we can say something about Credit Suisse and how regulators dealt with that, we’ve always been of the opinion that Credit Suisse was a weak bank and regulators could have stepped in earlier by cutting AT1 coupons. We call that loss absorbency on the going concern basis. The market wouldn’t have liked that per se, but it could have saved the bank on the longer run. So I think what regulators have learned from it is that loss absorbing capacity on a going concern basis is, in practice, difficult.

So the Swiss regulator has basically strengthened the regulation surrounding such events, while the Australian regulator has said, “well, the loss absorbency on the going concern basis doesn’t work. So we’re going to phase out AT1s altogether.”

And maybe the last thing on that is that 90% of all AT1s are issued by European banks. So basically the future of AT1s is determined by the European regulators. They still very much support the instrument for European banks. They have roughly 200 billion to 250 billion of AT1s outstanding. If you were to replace that with core T1, that would mean a massive rights issue for banks. So nobody would like that to happen. So the future of AT1 is still very bright.

EM: Daniel what’s the future of corporate hybrids? Have there been any notable default events there that might have scared investors?

DE: Not like in the case of Credit Suisse. There have been historical defaults, notable defaults in the corporate hybrid space. One prominent example is the French supermarket chain Casino, which defaulted last year. A lot of clients typically ask, “Have there ever been defaults in corporate hybrids?” Because in the end, corporate hybrids are typically issued from investment grade corporates, which also happen to be in relatively defensive sectors like utilities and telecommunications.

So there shouldn’t be many defaults given the defensiveness of the asset class. But there have been defaults like in the case that I mentioned. But it is important to note that that particular default of Casino, which happened last year, came from an issuer that had a high yield rating already upon issuance, which was almost 20 years ago. It's also important to mention that the strategy that we run at Robeco is a more conservative strategy, which is benchmarked against an investment grade universe of corporate hybrids. So we wouldn’t be invested in this kind of instrument.

EM: So interesting, Daniel, to see how ratings agencies and the way they look at corporate hybrids, how that could influence the market. And I understand that Moody’s, for instance, have changed their methodology around corporate hybrids.

DE: That’s a good point, Erika. So in February of this year, Moody’s updated its methodology of how they assign equity credit to corporate hybrids. So some important developments there. So the main changes are subordinated bonds, US subordinated bonds, are moving to 50% equity credit from 25% previously. And that Moody’s now allows the use of a 30 non-call structure instead of a 60 non-call or perpetual structure that we were discussing earlier. So this 30 non-call structure will receive a 50% equity content.

And the main change from an issuer’s perspective is that subordinated debt and preferred stock will now receive the same equity treatment by Moody’s. That also means that the 30-year dated non-step corporate hybrid will receive the same equity treatment at all rating agencies as preferred shares, while at the same time being tax deductible. So from an issuer perspective, there’s a strong incentive now to issue corporate hybrids over preferred stock. And we have already been seeing that since the start of the year, the floodgates have been open for US issuers to issue corporate hybrids with the amount of corporate hybrids in US dollars issued year to date, surpassing euros for the first time in several years.

EM: So changes such as these, Daniel could actually help the asset class to grow and to be more liquid, be more attractive, right?

DE: Absolutely. So corporate hybrids, being traditionally a European asset class, have seen better liquidity on the Euro side. But with the innovation that Moody’s brings forward in this methodology change, we have seen significant improvements in the liquidity of dollar-denominated hybrids. And in addition, we have seen a new cohort of investors jumping into the asset class.

EM: So on that point, new issuance, I gather new issuance so far this year has been quite attractive. I don’t know if it’s substantially better than last year, but there is appetite and interest on the issuer side but also on the demand side.

JWK: We’ve seen, especially since the summer, an enormous amount of new issuance in AT1. So if I have counted correctly, close to 15 billion of new issue. That is all new issues from banks who call their existing AT1s.

EM: So it’s replacing…

JWK: …they are replacing their existing. So in terms of net new issuance, we don’t expect a lot of debt in the coming years actually. So we would say from a technical perspective that is interesting, because you get don’t get a lot of new issuance, so there’s not a lot of supply. We expect a continued strong demand for AT1s. So that will be a positive.

EM: So that’s the technical side of things: how issuance affects market dynamics. But now what about the broader sort of macro picture and how rates are changing? What views are on interest rates, how markets might be perceiving risks or uncertainties related to the US election, for example. So Daniel sketched the picture. Now how do you perceive the market? What are you expecting from your asset class?

DE: That’s a good question, Erika. I think under an uncertain macro backdrop, I think that’s what we’re facing now, with probabilities of a soft landing and hard landing oscillating on a day-to-day basis. And we’ve seen already a pretty sharp decline in interest rates. I think that presents an interesting opportunity to invest in corporate hybrids vis-à-vis for instance high yield debt in the sense that from a total return perspective, you do take more duration risk in corporate hybrids versus high yield. So you will win an environment where interest rates are declining.

And on the other hand, you are going up in quality when you’re investing in corporate hybrids. So on a spread performance basis, I do expect corporate hybrids to outperform high yield debt in a situation where the market weakens. But also the entry point is quite attractive, where the pickup in investing high yield debt over corporate hybrids has near historical lows. And as a result, I think no matter what is your macro outlook, it just makes sense from an asset allocation perspective to shift more risk toward a corporate hybrid.

EM: Jan Willem on the financial side?

JWK: Yeah similar. So it seems we’re heading for a soft landing in the US. Europe is limping along I would say, but not with dramatically negative growth numbers. So growth is slowing. You see inflation falling. So central banks have started their rate-cutting cycle. We think that’s a pretty good scenario for banks in general. But yields for AT1s, for example, [are] at 7% or slightly higher. I think you have a very interesting backdrop to buy those instruments.

I do want to flag one thing as well on AT1 is their long-term performance track record. So the index we use started in mid-2014. So remember it’s a quite a new instrument. And if you had invested right at the start of the index, you would by now have doubled your investment. So that’s roughly 7% annualized return per year. And interestingly enough, that’s way better than if you would have put your money into an equity bank index.

EM: So in closing. Looking at the context of the environment, the macro picture, what would you say are your guiding principles as portfolio managers? What’s critical to success in running a portfolio that outperforms the benchmark, that outperforms other asset classes, that gives investors the high income that they desire? Daniel.

DE: As a portfolio manager in corporate hybrids, I think there are three key principles that help us, guide us in the market, two of which are fundamental to our investment process in a broader sense. So as a reminder to our audience, the two key pillars of our investment process are having a top-down view in credit markets to determine the overall risk positioning. And then a deep, fundamental bottom-up research to identify the best single-name opportunities and avoiding the losers.

I think a third element is having deep knowledge on the structural differences between corporate hybrids. This knowledge does extend beyond basic distinctions between hybrids with coupon step-ups and those without. So just to give you an example, some issuers like Enbridge and TransCanada, have mandatory conversion features into preferred shares, while others, for example, Dominion Energy, have a coupon floor. So these structural differences can also be off opportunities for the portfolio manager that is able to identify them. And as a result, I think for a successful portfolio manager in corporate hybrids, key understanding to those structural differences is essential.

EM: Yeah. That struck me when you were describing how the instruments work, how highly complex it is. And, you know, it’s understanding finance and presumably mathematics and how that affects the present value of an instrument. So you really have to know what you’re doing. So it’s a sort of highly active approach. Jan Willem, your remarks on this?

JWK: Well, very much agree with what Daniel’s saying. So stick with the process for the Robeco Credit team. That is deeply fundamental bottom-up research. I think we do that very well. Active issuer selection is key. You cannot buy AT1 or corporate hybrids in ETF form. You need to do your homework. So that is very important. And as Daniel has explained, things can become very technical. So also your instrument selection where you want to be in a capital structure. Banks have a quite complicated capital structure as well, with AT1, Tier 2, senior non-preferred debt, senior preferred debt.

So where in the capital structure, but also which instrument, and not all AT1 are designed in the same way. Some have higher reset spreads, as we call it. Some have longer, some have shorter maturities, etc. some have different conversion mechanisms. So knowing which AT1s to buy and how to price for different technicalities is really important.

EM: Jan William and Daniel, thank you so much. I really learned a lot and really enjoyed this conversation. Thanks for joining us.

DE: Yeah. Thank you Erika.

JWK: Thank you Erika.

EM: And to listeners, thank you for being here with us. We publish a new episode every month covering a range of investment related topics. This podcast and Robeco’s Markets podcast, In Tune With The Markets, are available on all major podcast platforms and on the Robeco website. If you subscribe, you’ll receive a notification as soon as the new episode is published. Now, in the meantime, please rate the show and share the show link with a friend. Until next time.

Thanks for joining this Robeco podcast. Please tune in next time as well. Important information. This publication is intended for professional investors. The podcast was brought to you by Robeco and in the US by Robeco Institutional Asset Management US Inc, a Delaware corporation as well as an investment advisor registered with the US Securities and Exchange Commission. Robeco Institutional Asset Management US is a wholly owned subsidiary of ORIX Corporation Europe N.V., a Dutch investment management firm located in Rotterdam, the Netherlands. Robeco Institutional Asset Management B.V. has a license as manager of UCITS and AIFS for the Netherlands Authority for the Financial Markets in Amsterdam.