Analysis: Peak rates boost U.S. demand for riskier form of corporate debt

Affiliated Managers

15/03/2024 10:00

By Shankar Ramakrishnan
       March 15 (Reuters) - The U.S. market for one of the
riskiest types of corporate debt is resurging this year, as
companies cater to investor demand for assets that can lock in
high yields for several years ahead of an expected decline in
interest rates.
    Holders of these bonds, called junior subordinated debt, are
among the last to be paid in case of a default and companies can
defer interest payments. 
        The reward for such high risk is yields that exceed
those of senior bonds, for maturities of up to 40 years, though
issuers typically call, or redeem, the bonds in five or 10
years.
        Like stocks, these hybrid bonds rank low in a company's
capital structure, but they resemble bonds with interest
payments.
  
    With the Federal Reserve widely expected to start cutting
rates later this year, investors are scrambling to get their
hands on securities that will pay the current levels of high
interest for years to come.
    To meet this demand, five companies this year have issued
$4.6 billion of junior subordinated debt, and a sixth hit the
market on Thursday. This pace is significantly faster than in
the last two years, Barclays data shows, with $8 billion issued
in full-year 2023.
    Barclays' analyst Bradford Elliott estimates sales of junior
subordinated bonds could reach $15 billion to $20 billion this
year. Investors have plowed in a net $1 billion into funds that
invest in hybrid bonds since October, he noted. 
        The renewed interest is giving companies an additional
financing option as debt comes due. 
  
    
    INCREASING ATTRACTIVENESS
    A change in Moody's rating methodology on Feb. 1 has made
hybrid bonds more attractive for companies, bankers and analysts
said.
    Last month, Moody's said it would start giving 50% equity
credit when rating a company's hybrid debt or count half of an
issuer's subordinated debt as equity capital, up from 25%
previously. The move, in line with S&P and Fitch, means
companies can reliably use hybrid bonds to raise more capital
without hurting their credit ratings.
    Among issuers of junior subordinated debt so far this year,
NextEra Energy Capital  NEE.N  used some of the proceeds to
refinance short-term commercial paper. 
    Energy Transfer  ET.N , which owns and operates a
diversified portfolio of energy assets, said it refinanced
preferred shares, another type of hybrid bond that is riskier
than junior subordinated debt.
    Daniel Botoff, global head of debt capital market syndicate
at RBC Capital Markets, said junior subordinated debt also had a
tax advantage over preferred shares.
    "It is more cost-efficient for companies to issue junior
subordinated debt whose interest payments were tax-deductible to
refinance taxable preferred stock that is becoming callable,"
Botoff said.
    
    STRONG DEMAND
    With strong demand, the average credit spreads on corporate
hybrid bonds, or the premium paid over Treasuries, tightened
nearly 200 basis points since it peaked at 523 basis points in
October, Elliott said.
    The six companies that have issued subordinated bonds this
year paid 6% to 8% in yields, just 150-200 basis points more
than on their higher ranked senior bonds.
    In another sign of firm demand, Energy Transfer increased
its offering in January to $800 million from an initial $500
million. It received $5 billion in orders, Informa Global
Markets data showed.
    Hybrid bonds are "sensitive to macro conditions," said Tim
Crawmer, global credit strategist at Payden & Rygel. "They have
a higher correlation to improving credit quality and improving
equity risk sentiment than they do to interest rates." 

 (Reporting by Shankar Ramakrishnan; additional reporting by
Davide Barbuscia; editing by Paritosh Bansal and Richard Chang)
 ((Shankar.Ramakrishnan@thomsonreuters.com; +1 2017590156;))