Corporate hybrids: what could be electrifying for the market
Hybrids have clearly outperformed corporate bonds this year. Looking ahead to the coming months and years, investors should keep an eye on two developments. These could prove decisive for the investment segment.
Hagen Fuchs , Senior Portfolio Manager, and Daniele Paglia, Senior Portfolio Manager
The annual results clearly show that subordinated corporate bonds had another good year. Over the past twelve months, the investment segment of corporate hybrids performed strongly at around 13.96% (measured against the ICE BofA Global Hybrid Non-Financial Corporate (TR) index, capped at 3% per issuer, hedged in EUR). This is almost double the return on corporate bonds over the same period, which rose by around 7.24% measured against the ICE BofA Euro Corporate Index, hedged in local currencies to the euro.
Significantly higher returns
As it turns out, the outperformance of ‘hybrids’ was due to several factors. On the one hand, the higher current yield of around 1.5 percentage points compared to standard bonds had a positive effect, measured by the yield to worst of the ICE BofA Global Hybrid Non-Financial Corporate (TR) index, constrained 3% per issuer, compared to the ICE BofA Euro Corporate Index. The 22 basis point smaller decline in credit spreads in the subordinated debt segment also proved to be a strong impetus. Furthermore, the performance of corporate hybrids was achieved despite the strong interest rate movements of the last 12 months at significantly lower volatility compared to the ICE BofA Euro Corporate Index. This is due to the lower interest rate sensitivity of the hybrid segment.
The fund "Swisscanto LU Bond Fund-Responsible Corporate Hybrid" also benefited from this; thanks to the active selection of issuers and bonds, it was able to significantly outperform both the benchmark and comparable competitor products.
In addition to these drivers, the subordinated corporate bond market has seen several interesting developments that will shape the segment for years to come. One is the impact of the boom in artificial intelligence (AI) and the energy transition on the utility industry. On the other hand, the previously unfavourable conditions for hybrid car sales in the US have improved significantly. These two developments deserve a closer look.
AI boom and energy transition put utilities in a bind
The rapid progress of AI has not only revolutionised the technology industry, but is also having a profound impact on other sectors, particularly energy. This is because the increasing demand for computing power for AI applications has led to a huge increase in energy demand, particularly due to the growth of data centres. These form the backbone of the AI infrastructure and require huge amounts of electricity to process and store the vast amounts of data.
As a result, US utilities such as Dominion Energy and CenterPoint Energy are challenged to meet this growing energy demand. According to the Edison Electric Institute (EEI), the investment required could exceed $400 billion by 2026. And that's not all. In addition to the huge demand for AI applications, the energy transition to renewable energy sources such as solar and wind will require utilities to invest heavily in new capacity and upgrades to existing infrastructure.
A middle ground between equities and bonds
These developments highlight the urgent need for utilities to raise capital. One way to raise capital would be to issue additional shares, but this seems unrealistic due to the high costs involved. Alternatively, companies could finance investment by issuing new bonds. However, this would significantly increase leverage - with negative consequences for creditworthiness.
Because corporate hybrids have characteristics of both debt and equity, they are an interesting middle ground for companies looking for a flexible financing option. It is no coincidence that corporate hybrids are now part of the standard corporate financing toolkit in Europe. Investors value them as an asset class because they offer significantly higher yields than traditional corporate bonds. High credit ratings may also seem attractive. In the US, however, this format has not been very common due to unfavourable conditions.
However, this has changed significantly since the beginning of 2024.
Strong growth in US hybrids thanks to change in rating methodology
The change in rating methodology by one of the leading US rating agencies, Moody's, last February (see box) has played a key role. Since then, this change has made corporate hybrid financing look much more attractive. The combination of high investment needs and the change in rating methodology has already had an impact. According to financial data provider Bloomberg, US utilities have raised around USD 18bn through subordinated debt issuance in 2024, nine times the amount raised in the previous year.
Hurdles lowered for US companies
With the change in rating methodology, Moody's now allows US companies to classify 50% of the capital raised through hybrid bonds as equity, up from 25% (Europe: 50%). In addition, companies benefit from the tax deductibility of interest payments, further reducing the cost of this form of financing. Prior to the change in methodology, US companies typically issued preferred stock, which is also classified as 50% equity, but does not allow for the tax deductibility of dividends. In addition, the investor base for corporate hybrids is much broader than for preferred shares. The latter are less popular with large institutional investors, which limits demand.
A look at the 'old continent' shows the potential that regime change could continue to offer in the future. European corporate hybrids have a uniform structure, which offers clear advantages for both investors and issuers. This has contributed to the rapid growth of the asset class over the past 15 years, as a look at 2010 shows (see chart below, excluding financial services). We believe that the adjustment of Moody's rating methodology should lead to the development of a standardised market in the US that is very similar to the European model and therefore more investor friendly.
Strong growth in the market for corporate hybrids
Outstanding volume in USD millions (ICE BofA Global Hybrid Non-Financial Corporate Index (GNEC) + ICE BofA Global Hybrid Non-Financial High Yield Index (HNEC) + 2024 USD Non-Fin Jun Sub Issuance)
Favourable environment expected
To date, the corporate hybrid market has been heavily dominated by European issuers. With the increasing participation of US companies, the segment will expand geographically and diversify. We expect US companies from other sectors, in addition to utilities, to use the instrument to efficiently implement their investment programmes. The first example of this was the US healthcare company CVS Health, which issued two bonds on 3 December last year. As a result, the proportion of USD-denominated bonds in the corporate hybrid universe is likely to increase significantly - a further plus for diversification from an investor's perspective. The entry of US issuers is also likely to unlock additional investor demand globally.
With demand for hybrids already significantly outstripping supply, we expect the environment for this investment segment to remain favourable in 2025, with a performance of around 4.5%, thanks in part to the high current yield.
Funds on the topic of corporate hybrids
Funds on the topic of corporate hybrids
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Legal Disclaimer Switzerland and international
This document only serves advertising and information purposes, is for distribution in Switzerland only and is not directed at persons in whose nationality or place of residence prohibit access to such information under applicable law. Where not indicated otherwise, the information concerns the collective investment schemes under the law of Luxembourg managed by Swisscanto Asset Management International S.A. (hereinafter "Swisscanto Funds"). The products described are undertakings for collective investment in transferable securities (UCITS) within the meaning of EU Directive 2009/65/EC, which is governed by Luxembourg law and subject to the supervision of the Luxembourg supervisory authority (CSSF). This document does not constitute a solicitation or invitation to subscribe or make an offer to purchase any securities, nor does it form the basis of any contract or obligation of any kind. The sole binding basis for the acquisition of Swisscanto Funds are the respective legal documents (management regulations, sales prospectuses and key information documents (PRIIP KID), as well as financial reports), which can be obtained free of charge at https://products.swisscanto.com as well as at Swisscanto Fondsleitung AG, Bahnhofstrasse 9, CH-8001 Zurich (also acting as representative of the Luxembourg Swisscanto funds in Switzerland) or in all offices of Zürcher Kantonalbank. Paying Agent for the Luxembourg Swisscanto funds in Switzerland is Zürcher Kantonalbank, Bahnhofstrasse 9, CH-8001 Zurich. Information about the sustainability-relevant aspects in accordance with the Regulation (EU) 2019/2088 as well as Swisscanto's strategy for the promotion of sustainability and the pursuit of sustainability goals in the fund investment process are available on the same website. The sub-fund referred to in the document is subject to Article 9 of Regulation (EU) 2019/2088. The distribution of the fund may be suspended at any time. Investors will be informed about the deregistration in due time. The investment involves risks, in particular those of fluctuations in value and earnings. Investments in foreign currencies are subject to exchange rate fluctuations. Past performance is neither an indicator nor a guarantee of future success. The risks are described in the sales prospectus and in the PRIIP KID. The information contained in this document has been compiled with the greatest care. Despite professional procedures, the correctness, completeness and topicality of the information cannot be guaranteed. Any liability for investments based on this document will be rejected. The document does not release the recipient from his or her own judgment. In particular, the recipient is recommended to check the information for compatibility with his or her personal circumstances as well as for legal, tax and other consequences, if necessary, with the help of an advisor. The prospectus and PRIIP KID should be read before making any final investment decision. The products and services described in this document are not available to U.S. persons under the relevant regulations (in particular Regulation S under the U.S. Securities Act of 1933).
Data as at (where not stated otherwise): 11.2024
© Zürcher Kantonalbank. All rights reserved.
This document only serves advertising and information purposes and is not directed at persons in whose nationality or place of residence prohibit access to such information under applicable law. Where not indicated otherwise, the information concerns the collective investment schemes under the law of Luxembourg managed by Swisscanto Asset Management International S.A. (hereinafter "Swisscanto Funds"). The products described are undertakings for collective investment in transferable securities (UCITS) within the meaning of EU Directive 2009/65/EC, which is governed by Luxembourg law and subject to the supervision of the Luxembourg supervisory authority (CSSF).
This document does not constitute a solicitation or invitation to subscribe or make an offer to purchase any securities, nor does it form the basis of any contract or obligation of any kind. The sole binding basis for the acquisition of Swisscanto Funds are the respective published legal documents (management regulations, sales prospectuses and key information documents (PRIIP KID), as well as financial reports), which can be obtained free of charge at https://products.swisscanto.com/. Information about the sustainability-relevant aspects in accordance with the Regulation (EU) 2019/2088 as well as Swisscanto's strategy for the promotion of sustainability and the pursuit of sustainability goals in the fund investment process are available on the same website. The sub-fund referred to in the document is subject to Article 9 of Regulation (EU) 2019/2088.
The distribution of the fund may be suspended at any time. Investors will be informed about the deregistration in due time. The investment involves risks, in particular those of fluctuations in value and earnings. Investments in foreign currencies are subject to exchange rate fluctuations. Past performance is neither an indicator nor a guarantee of future success. The risks are described in the sales prospectus and in the PRIIP KID. The information contained in this document has been compiled with the greatest care. Despite professional procedures, the correctness, completeness and topicality of the information cannot be guaranteed. Any liability for investments based on this document will be rejected. The document does not release the recipient from his or her own judgment. In particular, the recipient is recommended to check the information for compatibility with his or her personal circumstances as well as for legal, tax and other consequences, if necessary, with the help of an advisor. The prospectus and PRIIP KID should be read before making any final investment decision.
An overview of investors' rights is available at https://www.swisscanto.com/int/en/legal/summary-of-investor-rights.html.
The products and services described in this document are not available to U.S. persons under the relevant regulations (in particular Regulation S under the U.S. Securities Act of 1933). Data as at (where not stated otherwise): 11.2024
© Zürcher Kantonalbank. All rights reserved.
