Hybrid bonds: Enel of a handy instrument with ratings at stake

Hybrid bonds look a pretty good deal for debt investors — which may help explain why there is a queue to buy them. Italian utility Enel kicked off 2023 with a €1.75bn offering. There was initial demand for €15bn.

Investors who bought the bonds, which sit between equity and debt in the capital structure, are getting a handsome return. Enel’s hybrids pay something in the region of 6.5 per cent, or about 250 basis points higher than its senior debt of a similar maturity.

That is a lot less than the company would have had to pay last year. Back then, tough credit markets and a gloomy economic outlook drove up the yield on existing hybrid bonds above 8 per cent. Tighter yields reflects a more sanguine environment and greater faith in Enel’s prospects.

But 250bp is still quite a big spread, for limited additional risk. Enel’s credit default swap, which pays out if the company goes bust, is trading at levels which suggest a bust is improbable.

Hybrid bondholders are likely to be treated like the ordinary kind, unless the company’s fortunes deteriorate. That is when their subordinated status would matter. Issuers are allowed to defer interest payments and maturities without triggering defaults. They are unlikely to do so if they can help it. Banks have deferred maturities in the past, but it is hard to think of an example outside the financial sector.

There is a step-up in the coupons over time. As a counterweight to this benefit, credit rating agencies could stop giving the bonds partial equity credit, removing much of their raison d’être.

Despite that, companies have rushed to issue hybrids, especially utilities. The European market for corporate hybrid bonds has historically been about €30bn-€40bn a year. That figure will rise.

Issuers are not just keen on the flexibility these instruments provide when things go wrong. They also like being able to raise new debt without busting their credit metrics and risking ratings downgrades. That saves the issuer a lot of money on the rest of its debt. Hybrid investors are reaping the benefit.

The Lex team is interested in hearing more from readers. Please tell us what you think of hybrid bonds in the comments section below.