The important caveat with this point is that in most structures the coupons are cumulative and compounding, meaning that if the firm decides to start paying dividends again it will have to pay all deferred coupons along with any interest accrued. As a result it is very expensive to defer coupons, and companies would be reluctant to do so unless they are in real distress.
The third risk is that posed by any special event calls. These are particular instances where the issuer has the option to call the hybrid bonds at a price that is normally very close to par. Common call clauses include changes in the ratings methodologies used by rating agencies, regulatory accounting treatments, a change of control in the ownership of a company, and tax treatments.
If one can become comfortable with these risks, the return profile of hybrids can be attractive, but how can investors decipher it?
“Essentially it can be divided into four components,” says Lundie. “The first two cover rates and ‘senior spread’, which represent the compensation for the credit risk at the senior level. “Further down the structure, we also consider the ‘subordination premium’. This provides compensation for a lower recovery in case of default. Finally, the ‘structure premium’ reflects the key risks of hybrids discussed above, and is by far the largest component of total return for a hybrid instrument.”
Marks agrees: “There is no getting away from the fact that these bonds are higher beta than senior investment grade bonds. The risk here is spread risk. If we were to see significant widening in senior spreads, for non-financial investment grade bonds – and when I say significant I mean several hundred bps – at that stage we might start considering whether or not these bonds might be called at the first call date.”
While a risk exists, many hybrid products have been structured in such a way that if they fail to get called at the expected time they lose their equity status from the rating agencies, so effectively become expensive senior debt.
