Subordinated bonds issued by non-financial companies (corporate hybrids) are a solid alternative to high-yield bonds for risk-conscious investors in consideration of the impending recession in the Eurozone and the USA. At around 7.6%, the yield on these corporate bonds is currently close to double that of senior investment-grade corporate bonds and almost the same as the yield on high-yield bonds. »However, default rates of high-yield bonds amounted to over 12% in periods of financial market stress, while the issuers of corporate hybrids showed almost no defaults due to their solid investment grade rating,« notes Michael Hess, head of portfolio management corporate bonds at asset manager Bantleon. »Coupled with the very attractive yield, corporate hybrids offer an almost unbeatable risk-return profile.« Given the continued high demand, an attractive performance of over 7% is possible in an environment of unchanged interest rates and risk premia over a 12-month period.
Avoid subordinated bonds from financial companies
When selecting subordinated bonds, however, it should be noted that there are major differences in securities issued by non-financial companies (corporate hybrids) versus financial companies (financial hybrids). Banks and insurers can be forced to write down subordinated bonds to strengthen their capital ratio. The complete write-down of AT1 bonds of Credit Suisse with a volume of 16 billion euros served as a warning. »In addition, bonds from non-financial companies offer significantly more opportunities to diversify risks more broadly across different sectors,« explains Hess. »This is the reason why we invest exclusively in subordinated bonds from non-financial companies and consistently avoid those from financial companies.«
Active management required
Investor interest in corporate hybrids has been growing steadily due to their attractive characteristics since the segment reached a more mature stage in 2019. Against this background and in view of the good results achieved through active management, the mutual fund Bantleon Select Corporate Hybrids (LU2038754953) has now exceeded the volume mark of 100 million euros. Hess advises against passive implementation via an ETF: »In order to consistently minimise risks, a detailed prospectus analysis is essential in addition to a thorough issuer analysis, despite the gradual homogenisation of the corporate hybrids market in terms of covenants. Here, it is important to identify special cases in order to protect oneself from disadvantageous clauses – for example, continuing equity credit after the first termination date. In phases of structurally rising interest rates, corporate hybrids are also subject to a significantly increased price and liquidity risk, which must be actively managed.«
