Holders of these bonds, called junior subordinated debt, are among the last to be paid in case of a default and companies can defer interest payments.
The reward for such high risk is yields that exceed those of senior bonds, for maturities of up to 40 years, though issuers typically call, or redeem, the bonds in five or 10 years.
Like stocks, these hybrid bonds rank low in a company’s capital structure, but they resemble bonds with interest payments.
With the Federal Reserve widely expected to start cutting rates later this year, investors are scrambling to get their hands on securities that will pay the current levels of high interest for years to come.
To meet this demand, five companies this year have issued $4.6 billion of junior subordinated debt, and a sixth hit the market on Thursday. This pace is significantly faster than in the last two years, Barclays data shows, with $8 billion issued in full-year 2023. Barclays’ analyst Bradford Elliott estimates sales of junior subordinated bonds could reach $15 billion to $20 billion this year. Investors have plowed in a net $1 billion into funds that invest in hybrid bonds since October, he noted. The renewed interest is giving companies an additional financing option as debt comes due.
INCREASING ATTRACTIVENESS
A change in Moody’s rating methodology on Feb. 1 has made hybrid bonds more attractive for companies, bankers and analysts said.
Last month, Moody’s said it would start giving 50% equity credit when rating a company’s hybrid debt or count half of an issuer’s subordinated debt as equity capital, up from 25% previously. The move, in line with S&P and Fitch, means companies can reliably use hybrid bonds to raise more capital without hurting their credit ratings.
Among issuers of junior subordinated debt so far this year, NextEra Energy Capital used some of the proceeds to refinance short-term commercial paper.
Energy Transfer, which owns and operates a diversified portfolio of energy assets, said it refinanced preferred shares, another type of hybrid bond that is riskier than junior subordinated debt.
Daniel Botoff, global head of debt capital market syndicate at RBC Capital Markets, said junior subordinated debt also had a tax advantage over preferred shares.
“It is more cost-efficient for companies to issue junior subordinated debt whose interest payments were tax-deductible to refinance taxable preferred stock that is becoming callable,” Botoff said.
STRONG DEMAND
With strong demand, the average credit spreads on corporate hybrid bonds, or the premium paid over Treasuries, tightened nearly 200 basis points since it peaked at 523 basis points in October, Elliott said.
The six companies that have issued subordinated bonds this year paid 6% to 8% in yields, just 150-200 basis points more than on their higher ranked senior bonds.
In another sign of firm demand, Energy Transfer increased its offering in January to $800 million from an initial $500 million. It received $5 billion in orders, Informa Global Markets data showed.
Hybrid bonds are “sensitive to macro conditions,” said Tim Crawmer, global credit strategist at Payden & Rygel. “They have a higher correlation to improving credit quality and improving equity risk sentiment than they do to interest rates.”