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Bond Distortions Heighten Allure of Europe’s Hybrid Debt Markets

The appeal of risky debt is deepening in Europe, even as credit quality slides and compensation shrinks.

The balance has shifted in favor of companies, which are on pace to sell a record amount of hybrid bonds this year. Non-financial borrowers have already issued more than 19 billion euros ($21 billion) of the low-ranking notes following 28 billion euros in 2014, according to data compiled by Bloomberg, and analysts are upping their forecasts.

Borrowers are benefiting as quantitative easing measures suppress yields across the region, encouraging investors to relax their standards. Average ratings on hybrid bonds, which combine elements of debt and equity, fell to the lowest in eight months in February, according to CreditSights Inc.

“The main risk for hybrids looking ahead is that investors get more and more comfortable because of QE, while companies become more aggressive,” said Thibault Colle, a London-based credit strategist at UBS Group AG. “In this environment where there’s no yield out there, these bonds are getting lots of demand.”

The European Central Bank’s efforts to bolster the economy are distorting credit markets, with about $1.6 trillion of government notes now yielding less than zero and the average yield for investment-grade bonds in Europe at 1 percent.

Hybrid bonds globally paid an average yield of 2.84 percent on Thursday after dropping to a record 2.67 percent in March, Bank of America Merrill Lynch index data show.

Higher Forecasts

The securities typically have no maturity although they can be called early. Investors like them because they pay more than higher-ranking corporate bonds and they’re popular with borrowers because ratings firms count part of the bonds as equity, reducing their assessment of an issuer’s indebtedness.

“Issuers are getting the better end of the bargain than investors,” said Stefan Isaacs, a London-based fund manager at M&G Investments, which oversees more than 257 billion pounds ($394 billion) of assets. “The real reason why this works right now is because of the scarcity of yield. If we didn’t have QE, you’d struggle to make a case for owning these hybrids at these levels.”

The flood of hybrid sales prompted analysts at Societe Generale SA and ING Bank NV to increase issuance forecasts for this year to 50 billion euros and 42 billion euros, respectively, from 30 billion euros each.

Companies are taking advantage of investor demand for the securities by issuing bonds that improve their debt metrics and protects credit ratings.

Air France

Air France-KLM Group in March sold 400 million euros of hybrid bonds that count as equity and have coupons that may depend on the company’s ability to pay dividends, even though the airline hasn’t paid shareholder coupons since 2008. Investors were so enamored of the deal that the company increased its size by 200 million euros and reduced the yield by 0.875 percentage point.

The Paris-based carrier lowered its net debt target for this year to 4.4 billion euros from 4.6 billion euros after the sale, according to a statement on April 10.

The securities are also popular with borrowers seeking to fund acquisitions. Repsol SA, Spain’s largest energy company, sold 2 billion euros of the notes and may issue as much as 5 billion euros for its purchase of Canadian firm Talisman Energy Inc.

“Use of proceeds have developed from companies using hybrids just to protect their ratings, to using them for M&A activity,” said UBS’s Colle. “There’s nothing stopping companies using hybrids for dividends and share buybacks.”

Attractive Investments

Hybrid securities can be among the most attractive investments opportunities if selected carefully, said Bryan Wallace, a London-based investor at JPMorgan Asset Management, which has increased its holdings of the bonds this year.

Total SA, Europe’s third-biggest oil company, garnered 20 billion euros of investor interest for its sale of 5 billion euros of hybrid bonds in February. Dong Energy A/S, the Danish state-backed utility, this week sold 600 million euros of hybrid notes.

All hybrid bonds may be vulnerable to price swings when central banks start withdrawing liquidity, according to Wolfgang Kuhn, head of European credit at Aberdeen Asset Management Plc which manages about 323 billion pounds of assets.

“Even if the company is fundamentally sound, the bond can have strong price moves,” said London-based Kuhn. “Central banks have put out so much liquidity that when they want to take that back, it could be painful for hybrid spreads.”

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