Embracing the Shifts for Yield and Stability
Context
The European Central Bank (ECB) is gradually reducing its quantitative easing (QE) program and may halt its corporate bond purchases by the summer. This policy shift poses significant risks for the Euro-denominated corporate bond market, including potential large-scale outflows and heightened market illiquidity. Over the past 5-6 years, the ECB's aggressive bond purchasing program has crowded out many private investors from the € Corporate Bond market, leading to an artificial compression of yields and reduced volatility. As the ECB begins to taper, private investors are expected to re-enter the market, but this transition is likely to bring volatility and create opportunities for informed investors.
Trade Recommendation
Buy € Corporate Hybrid Bonds:
BP CAPITAL MARKETS PLC 3.250% PERP (Oil & Gas should continue to be positively supported by current elevated oil prices)
TELEFONICA EUROPE BV FRN + 4.375% PERP (Telecoms are cheap, defensive and mainly BBs)
FRANCE TELECOM 5.000% 2026-10-01
Hybrids selected from the following list: Invesco Euro Corporate Hybrid Bond UCITS ETF Dist | A2PVDY | IE00BKWD3966 (justetf.com)
Rationale
Hybrid bonds, which sit between debt and equity in a company’s capital structure, have already priced in the ECB’s impending liquidity withdrawal and are trading at attractive levels compared to other high-beta assets. During the ECB’s quantitative easing period, hybrids became highly sought after as investors, crowded out of the lower-yielding government and corporate bond markets, sought alternatives offering higher returns. However, with the ECB tapering QE and reducing its presence in the bond market, asset managers have begun to scale back their hybrid allocations, making the asset class less crowded and providing room for price appreciation.
Moreover, hybrids tend to underperform during periods of hawkish central bank policy but outperform when the focus shifts from concerns about rising interest rates to worries about slowing economic growth. As markets move from fearing higher yields to concerns about weaker growth, hybrids are positioned to outperform more volatile high-beta assets, such as Additional Tier 1 (AT1) bank bonds and High-Yield (HY) credit.
Upside Catalyst to Trade Recommendation
1. Supply-Side Dynamics:
The issuance of corporate hybrids is closely linked to mergers and acquisitions (M&A) activity, as companies often issue hybrids to protect their credit ratings when they take on additional leverage for M&A deals. In recent years, M&A activity surged, peaking in 2021, which led to higher hybrid issuance. However, with Eurozone economic sentiment weakening and policy uncertainty increasing, M&A activity is expected to decline, resulting in lower hybrid bond issuance going forward. Reduced supply should support higher prices for existing hybrids.
2. Sector Strength:
Hybrids are structurally defensive and less exposed to cyclical sectors. Approximately 70% of the Euro Corporate Hybrids Index is composed of non-cyclical sectors such as utilities, telecoms, and oil & gas. In contrast, only about 30% of the € High Yield (HY) market is similarly defensive. Companies in the oil & gas sector, in particular, are likely to benefit from continued high energy prices, while the significant presence of non-cyclicals will help limit downside volatility in a slowing growth environment.
3. Higher Quality Credit:
The hybrid bond market features issuers with relatively stronger credit profiles compared to the broader non-financial bond market. On average, the issuers of hybrid bonds have higher ratings at the senior level, with around half of all issuers rated A or higher and the remainder mostly rated BBB+. This high-quality credit profile further supports the case for investing in hybrids, as they are less vulnerable to default risk compared to lower-rated bonds, particularly in a weakening economic environment.
Risks
1. Sensitivity to ECB Tapering:
Corporate hybrids are among the most sensitive credit markets to the ECB’s QE program. They have historically underperformed during periods of tapering when interest rate or duration risks are high. In a market environment where growth remains resilient but rates continue to rise, hybrids may lag behind high-yield (HY) bonds, which are typically more sensitive to credit risk rather than duration.
However, if the ECB’s tapering proves to be less aggressive than expected, with duration risk continuing to dominate the market, hybrids could underperform their high-yield counterparts. This is particularly true during the later stages of the economic cycle, where high-yield bonds generally perform better when fundamental risks are still low.
2. Economic Downturn Risk:
In the event of a significant economic downturn, default risks may become more prominent. Although hybrids are higher rated than high-yield bonds, they are still more vulnerable than investment-grade senior debt. A sharp increase in default risk could weigh on hybrid bonds, especially those issued by lower-rated or highly leveraged companies.
Potential Hedge:
To mitigate this risk, investors could consider a hedge in the form of leveraged credit-linked notes (CLNs) tied to high-yield bonds. This strategy would allow investors to benefit from continued HY outperformance during periods of economic expansion while limiting downside exposure to hybrids in the event of severe underperformance.
*All data extracted from Bloomberg Terminal