Choppy markets expose risks of high beta hybrids

Fri Jun 7, 2013 9:21am EDT

* Credit selection more crucial as bonds trip on volatility

* Limited headroom on corporate hybrids after YTD 3.2% return

* Enel deal eyed as some peripheral issues feel the pinch

By Josie Cox

LONDON, June 7 (IFR) - Corporate hybrids' sharp outperformance year-to-date has run into a pick-up in global volatility that has hit high beta instruments hard, meaning that investors must now work on credit selection if they want to avoid being burnt.

The softening market has analysts raising concerns the subordinated product may no longer be compensating investors sufficiently for risk, especially after a rally that has surpassed almost every other credit sector.

Hybrids have been described as the "go-go sector" of 2013 following record issuance. So far this year, around EUR17bn-equivalent of European non-financial subordinated hybrids have priced in US dollars, euros and sterling.

According to Barclays credit strategists, corporate hybrids have returned around 3.2% so far in 2013 - trailing only bank Tier 1s, and notably ahead of high yield and lower tier 2 debt.

"Average hybrid spreads touched the tights last seen in the spring of 2011, which speaks to the diminishing room for further performance," they wrote on Friday.

Hong-Kong based conglomerate Hutchison Whampoa's EUR1.75bn perp non-call 5 Reg S bond, which printed with a record-low coupon of 3.75% in May, illustrates the risk investors now face.

The deal has dropped some 4 points in price terms to around 96, for a yield of 4.68% on Friday.

"Hybrids remain an important and valuable tool for many companies but the blip in markets has served as a rude awakening that they will be the first to suffer when times get tough," a syndicate banker admitted.

ENEL BETA BLOCKBUSTER

Some are now questioning whether the volatility will have implications for Enel, which on Friday finished marketing a potential triple currency hybrid, tipped to be EUR2-3bn in size.

The Italian utility, one of the world's most indebted, could end up paying significantly more than it expected, following a near 25% widening in the iTraxx Main index over the last three weeks.

Sources close to the deal have now said the issuer may wait for more stable market conditions, but on the flip side, investors are still upbeat about Enel's issuance prospects.

Syndicate officials agreed, pointing to the high volume of reverse inquiry for the potential trade, and highlighting that subordination premiums and the structure will be crucial to the deal's success.

But if the deal is launched into a weak market, this could add more pressure on to what is already showing signs of being an ailing sector, Societe Generale credit strategy Suki Mann said.

Jens Vanbrabant, London-based portfolio manager at ECM Asset Management, said he would recommend not taking too much directional risk until there is a solid catalyst for a rally.

"This is particularly true for hybrids which are high beta instruments by nature.

Arcelor Mittal's 8.75% USD650m perp NC5.5 and the triple tranche hybrid by BG Group, which have both performed strongly since pricing last year, are among the hybrids that Barclays recommends selling.

The bonds have gained 7 and between 9-12 points since pricing last year in September and June, respectively, leading analysts to question how much upside is left.

The strategists say that they would still recommend buying hybrids from defensive names in the utility, industrials and telecom sectors

"Further performance in corporate hybrids is likely to depend more on the correct security selection with fundamental and bond structure considerations coming back to the fore." (Reporting By Josie Cox; editing by Natalie Harrison and Alex Chambers)

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