Adding corporate hybrid debt to a fixed income portfolio could allow investors to exceed 4% annual yield without increasing their volatility and reducing the likelihood of experiencing losses. This is one of the main conclusions of the report Corporate Hybrid Debt, prepared by Swisscanto Asset Management International S.A. (Swisscanto), the Luxembourg-based asset manager of Zürcher Kantonalbank, and International Financial Analysts (Afi). The study estimates the global outstanding balance of corporate hybrid debt at over $350 billion and suggests it could exceed $750 billion if the US market reached a penetration level similar to that of Europe.
For the investor, corporate hybrids could offer a yield premium over the senior debt of the same issuer, without necessarily presenting the risk profile of a lower-rated bond. This is because a significant portion of the issuances comes from companies with senior investment grade ratings. The lower ratings that hybrids receive are mainly due to their subordination and capital component, and not necessarily to a lower credit quality of the issuer.
The analysis developed by Swisscanto and Afi is based on a benchmark portfolio that represents a conservative or moderate investor: 5% in cash, 65% in European and US government debt with intermediate maturities (3 to 7 years), and 30% in investment grade corporate credit, evenly split between euros and dollars. Between 2024 and 2026, a period marked by the normalisation of interest rates, this portfolio would have achieved an expected annual yield of 3.8%, with a volatility of 3.3% and a Sharpe ratio, which measures the return obtained per unit of risk, of 1.13.
If 10 points of investment grade credit are replaced with hybrid bonds, the expected yield would rise to 4.1% and the volatility would barely change (3.2%). The Sharpe ratio would improve from 1.13 to 1.28. Conversely, allocating 10% to European high yield would also enhance the base portfolio, but would lag behind with an expected yield of 3.9% and a Sharpe ratio of 1.23.
The experience of the last five years shows that carry has been the main source of profitability for hybrid debt. The coupon contributed 4.5% annually in the global index of non-financial investment grade corporate hybrids and 4.3% in the high yield hybrids. The European investment grade credit contributed 2.9%, the European high yield 3.8%; and the CoCos, 3.6%.
The higher coupon largely offset the negative impact of rising rates, which deducted 3.4% annually from investment grade hybrids and 2.8% from high yield. Thus, investment grade hybrids achieved an annualised return of 2.8%, compared to 0.1% for European investment grade credit. High yield hybrids reached 3.4%, slightly above the 3.2% of European high yield. The CoCos achieved the highest total return (3.8%), due to the narrowing of credit spreads.
Lower probability of loss and more protection against inflation
Seeking the additional yield that corporate hybrid debt can provide does not require taking on the default risk of high yield. The premium on hybrids is explained by their position in the issuer's capital structure. They are positioned behind senior debt and ahead of equity. However, the vast majority of issuers are companies with senior investment grade ratings.
Therefore, a hybrid with a BB+ rating from a utility rated BBB does not equate to a senior BB+ bond from a high yield company. In the former case, the additional risk is due to the subordination and structure of the instrument, not the solvency of the issuer.
This credit quality is reflected in the asset's history. In the main global indices, there has only been one default on hybrid debt: Casino, in 2023, when the company was already at the lowest levels of the high yield segment. In high yield, average default rates hover around 4%-5%.
Under the assumptions of the analysis developed in this report, the probability of loss over a 12-month period by incorporating hybrids into the portfolio could potentially be reduced to 10%, compared to 13% for the base portfolio. However, past returns do not guarantee future profits.
The possible protection against inflation is also an important issue. Assuming an inflation threshold of 2.5% per year, a portfolio with hybrids would increase the probability of beating that target from 62% to 70% over 12 months, and from 79.5% to 86% over five years.
Active management is key
The report warns that investing in corporate hybrids requires careful management. The instrument is subordinated and its liquidity is somewhat lower than that of senior debt, so in episodes of market downturns, its behaviour may resemble that of high yield more than that of senior investment grade credit. Therefore, Swisscanto and Afi believe that the allocation to hybrids should be adjusted to the risk budget, investment horizon, and liquidity tolerance of each investor. It also requires analysing each issuance: the first call date, the coupon reset spread, the step-ups, and the extension risk.
