Hybrid Bond Gamble Pays Off as Stimulus Spurs Gains

Investors who bought record amounts of hybrid notes from European companies seeking to protect credit ratings as they increased debt are being rewarded with gains outstripping both junk and investment-grade bonds.

About 75 percent of the 29 billion euros ($39 billion) of hybrid securities sold this year are trading above their issue price, according to data compiled by Bloomberg, beating the 67 percent of equivalent junk debt and 39 percent of high-grade new issues. Storebrand ASA’s notes due April 2043 lead increases with a 7.8 percent jump, followed by French utilities GDF Suez and Electricite de France SA with more than 5 percent gains.

Demand for the securities, which Royal Bank of Scotland Group Plc says pay as much as 3 percentage points more yield than senior debt, was boosted after European Central Bank President Mario Draghi pledged to keep interest rates at a record low for an “extended period.” The junior notes typically allow companies to borrow without damaging credit grades because ratings firms count 50 percent of the bonds as equity, reducing their assessment of an issuer’s indebtedness.

“Investors in solid investment-grade names like hybrids because they can get bigger yields from them than the companies’ senior bonds,” said Andrei Pashko, a Frankfurt-based portfolio manager at Deka Investment GmbH, who oversees about 100 million euros of hybrid bonds.

Capital Cushions

Hybrids are usually sold by banks to bolster capital cushions against losses and benefit non-financial companies that need to make capital investments, such as utilities. Buyers like the securities, which absorb losses before senior notes are impaired, because they typically allow them to get bigger coupon payments without having to buy the debt of lower-rated companies which stand more chance of defaulting.

GDF, the operator of Europe’s biggest natural-gas network, cut leverage to 2.3 times debt to earnings in the first half of the year from 2.5 times at the end of 2012. When the company sold 1.7 billion euros of hybrid notes last month it said in a statement that the securities will help strengthen its financial structure and improve financial flexibility.

“Hybrids have successfully contained leverage as conditions in Europe have become challenging,” said Haroon Hassan, an analyst at Mitsubishi UFJ Securities International Plc in London.

French Utilities

French utility companies dominated European hybrid sales, pricing around a third of deals denominated in euros, pounds and dollars, according to data compiled by Bloomberg. Issuance has surpassed the total 28 billion euros raised in 2012 and 2011 combined, when the securities’ popularity waned in the wake of the region’s debt crisis.

EDF, Europe’s biggest power generator, is the biggest seller of the securities, pricing almost 4 billion euros of the bonds on Jan. 22 followed by a $3 billion sale two days later. More companies will try to be innovative with their funding structures, according to the company’s Paris-based Head of Finance and Investments Stephane Tortajada.

“Companies seem to be thinking more about their capital structure these days, in the way that banks already have multi layers of capital,” he said in a Feb. 22 interview.

Enel SpA, Italy’s largest utility, plans to sell 5 billion euros of the bonds over two years to bolster its finances. Chief Executive Officer Fulvio Conti put the deal on hold in June when there was a credit market sell-off amid concern U.S. stimulus measures would be eased, although he said the Rome-based company would press ahead with the issue when conditions improved.

European Risk

“The performance reflects investors being prepared to take European risk,” said Martin Reeves, head of high yield at Legal & General Invest Management, which oversees about $2.45 billion of junk debt. “High-grade investors feel comfortable owing the hybrid if they know the name; if they want risk, the bonds do well, but if they’re risk-off then the bonds will perform badly.”

The decision by Moody’s Investors Service to change the way it assesses the debt and equity treatment of hybrid notes sold by junk companies will have little impact on the market, according to Oliver Krenn at Deutsche Asset Management in Frankfurt. Instead of treating the securities as a blend of equity and debt, the ratings firm will now class hybrids issued by speculative-grade firms as either entirely debt or equity.

Just two of the 45 issues from western European companies this year were from sub-investment grade borrowers. Junk debt is ranked below Baa3 by Moody’s and BBB- by Fitch Ratings and Standard & Poor’s.

Methodology Change

“I don’t think Moody’s methodology change will have a big impact as it doesn’t affect the recently-issued investment-grade hybrids,” said Krenn, who helps manage about 1.5 billion euros of corporate credit including hybrid bonds.

BNP Paribas SA is the biggest underwriter of hybrid sales from European companies this year, managing just over 11 percent of deals including GDF Suez’s three-part deal, Bloomberg data show. HSBC Holdings Plc arranged 9.3 percent of deals, followed by Deutsche Bank with an 8.6 percent share.

“The low rates and easing policy environment in Europe versus tapering risk in the U.S. will continue to favor European credit,” said Alberto Gallo, head of European macro credit research at RBS.

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