Outside of ‘vanilla’ fixed income securities – your standard corporate and government bonds – there exists a vast array of options for investors, most of which are little discussed. These range from relatively simple floating rate notes, to exotic products with various convertible or re-set features, which can be triggered in a number of scenarios. One area that has done particularly well in 2017 has been hybrid corporate bonds. These are fixed income securities that have some equity like features, such as:
1. Coupons can be skipped if certain pre-set conditions are not met
2. Coupons can be accumulated and paid at a later date
3. Bonds can be converted into equity, or repaid at anytime
This of course introduces a higher level of complexity, but also the potential for higher reward. At Canada Life Investments, we undertake our own fundamental credit analysis and spend a great deal of time understanding the risk/reward profile of each individual issue we add to the portfolio.
Due diligence brings due rewards
Looking at the hybrid corporate bond space, it is imperative that the issuing company is well-capitalised. This is because if capital levels fall below a minimum level; it can trigger a coupon being skipped. Therefore, although the potential yield on these bonds offer a very attractive spread compared to more orthodox instruments, without the requisite analysis, investors will miss out. Despite these risks, the asset class has been a strong performer in 2017, returning in the region of 10% globally.
Global hybrid corporate bonds (excl. Financials)
Source: Morningstar Direct, as at 30/11/2017. Performance of the ICE BofAML Global Hybrid Non-Financial Corporate Bond Index, in US dollars, from 31/12/16.
Where do we have exposure?
The majority of these subordinated structures prevail in the Financials sector, where regulation adds a layer of risk and provisions for the likelihood of default-like events. However, other sectors are also making use of subordinated papers, such as oil and gas, and we have been adding exposure to these in 2017.
For example, the LF Canlife Global Bond Fund holds a hybrid corporate bond issued by Total, the French oil major. Although volatile, the oil price has risen by more than 10% year-to-date, providing the business with a supportive macroeconomic backdrop. However, even in a more challenging macroeconomic environment, we believe the company is fundamentally sound, particularly as it generates significant operating cashflow. For example, on a trailing twelve month (TTM) basis, Total has generated nearly $6 billion in free cash flow (FCF), implying an FCF yield of more than 4%.
As a result of its standing as a strong issuer in a sometimes volatile sector, we are happy to take the extra risk in holding a more subordinated bond, as we believe the reward exceeds the risk taken in holding this asset.
Can the sector continue to do well?
Although hybrid corporates performed done well in 2017, we are more cautious on the outlook for 2018, particularly given they have enjoyed such a strong run. Whilst the synchronised global economic recovery is undoubtedly supportive of company performance, it has also led to the start of a monetary tightening cycle. The US Federal Reserve is well through its rate-hiking cycle, raising interest rates again last week, whilst the Bank of Canada and Bank of England have followed suit. In addition, the European Central Bank announced that, from January 2018, it would be tapering its huge quantitative easing programme.
Consequently, we must take into account that hybrid corporates will be one of the first areas to sell-off, be it through higher interest rates, or indeed the geopolitical risks that still remain globally. Therefore, we are currently reducing our exposure to the space, rotating into more defensive and high quality names as we near 2018.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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