Hybrid securities have found willing new buyers. Yield-hungry Asian investors are now snapping up the lion’s share of junior bond issues. Cheap financing helps juice their returns. But with yields at record lows, piling into subordinated corporate debt is risky. And a spike in default rates would leave investors with heavy losses.
Issuance of hybrid debt has tripled to $17.9 billion this year, according to Thomson Reuters. Much of the demand is coming from the east. Asian investors bought as much as 67 percent of the $500 million hybrid issued by RWE, the German utility, in March. Perpetual bonds, which have no maturity date, are also popular: Dutch lender Rabobank sold 66 percent of its $2 billion perpetual to Asian investors in late 2011.
The search for yield explains much of the enthusiasm. Coupons on hybrid bonds typically range from 5-10 percent - 3 percentage points above senior debt from the same issuer, according to bankers. Investors are also sweetening the deal with leverage from private banks. Assume an investor buys a bond paying a five percent coupon, half financed with debt costing 2 percent a year: the annual return jumps to 8 percent.
But this deal won’t look as sweet if rates rise and bond prices fall. Investors may be expecting issuers to repay the bonds ahead of schedule after a few years, as they often have an incentive to do so. But if spreads have widened, it won’t necessarily be in issuers’ interest to call the bonds. During the financial crisis several large banks surprised investors when they did not redeem bonds ahead of schedule.
Then there’s the risk of default. When companies go bust, holders of senior debt tend to get back about 40 percent of their principal, according to bankers. For subordinated bonds, the recovery rate is typically less than 10 percent.
There are now more individuals in Asia with more than $1 million to invest than in Europe or North America, according to Capgemini and RBS. Some of that cash is pouring into hybrids. But if the market turns, Asian investors - and the banks that lend to them - look the most exposed.