Reasons to be constructive on extension risk

Extension risk has been and will continue to be a hot topic in the fixed income market this year. So far we have seen a number of outstanding deals called and refinanced in the bank Additional Tier 1 (AT1) space, both economic and not, but in the non-financial world of corporate hybrids, supply has been much more subdued.

This is largely a consequence of issuers’ prudent refinancing in 2020 and 2021 leading to a lack of upcoming call dates, combined with generally poor market conditions year-to-date and the fact that corporate hybrids represent a smaller market overall than subordinated financials. All told, hybrid supply YTD stands at just €10bn versus a total of 
€41bn in the whole of 2021.
 
The market repricing of rates and credit spreads has rightly led to increasing fears of extension risk (non-call) in corporate hybrids, particularly those issued by real estate investment trusts (REITs), which are relative newcomers to the hybrids market. For many REIT issuers hybrids aren’t are a core part of their long term funding plans, but rather a cheap source of equity financing during a QE environment that no longer exists, and so this is a sector where extension risk is warranted in our view and this risk must be evaluated on a case-by-case basis. Nevertheless, some of the justified concern around extension risk in REIT bonds has spread across to other sectors, with market pricing at times suggesting even large defensive issuers such as utilities and telecoms companies may not call their hybrids at the first call date. However, we continue to see evidence that these fears are overdone. 

As a reminder, if a hybrid issuer does not call, the bond’s coupon resets to the initial credit spread over a reference rate (for example, the five-year euro swap rate). Given we are in a very different credit environment to when many of these deals were issued, looking at the economics alone would lead you to believe many of these bonds will not be called, since their reset levels are cheaper than current market pricing. However, there are a number of additional mechanics to consider when it comes to hybrids.

On Monday, following the shift in market sentiment on the back of last week’s soft US inflation print, Telefonica tested the appetite of the hybrids market issuing a €750m Green perpetual non-call six-year hybrid, which came with initial guidance of 7.625-7.75% and a concurrent tender of its upcoming 2023 call hybrids. Telefonica is a good candidate to be the first to test the market in a number of months; it’s a very well covered name, a big hybrids issuer with over €7bn outstanding, and this deal was widely expected after management confirmed the issuer’s commitment to the hybrid market in their recent results call. The wider market reaction to the deal was positive, a further signal that extension risk may be less of a concern for high quality issuers, leading the sector to rally 0.25-0.5 points on the day.

The initial price guidance was not as generous as many would have expected, with fair value for the deal in our view being around 7.25%. Regardless, the deal was very well received by investors with books closing over €4.75bn (over 6x covered) and pricing at 7.125% – surprisingly inside fair value. The somewhat aggressive tightening highlights the staggering demand for high-coupon, high-reset (and also notably in this case, green) assets, all of which are currently scarce in secondary. We suspect Telefonica will be very pleased to have priced inside fair value, and despite the sharp pricing the bond has traded well in secondary, currently bid at 101.6 having been issued at 100 – a win-win for issuer and investor. 
 
This deal has a very positive read-across for the corporate hybrid sector, in our view, since it is further evidence that management’s decision to call is not binary. Looking at the reset levels alone, you wouldn’t have expected Telefonica to exercise the March 2023 call on its outstanding hybrids. If not called, those bonds would have reset to a coupon of around 5.1%, much cheaper than the 7.125% deal the issuer just printed and a clear ‘out of the money’ call for management. This confirms our view that there are many factors that contribute to the call decision, as we highlighted in our blog earlier this year. Not calling can remove the 50% equity treatment of an issuer’s hybrids (bad news for leverage and ratings), and the reputational risk of a non-call can also restrict future access to this source of funding, both of which Telefonica’s management evidently values. 

The rally in the hybrids market over the past month does suggest that peak fear surrounding non-calls has passed, and this has removed some of the extension risk that was being priced in. For issuers with large hybrids curves, who rely on equity treatment for their ratings and have a proven track record of issuing throughout the cycle as well as strong financials able to weather higher interest costs, we expect calls even when they appear uneconomic. 
 
In our view, the Telefonica deal shows there is cash on the side-lines for the right bonds, which in this case are high-coupon, high-reset corporate hybrids. The yield on offer in this sector should continue to attract the attention of non-traditional hybrid investors, such as high yield and hedge fund investors, many of whom are now seeking higher returns for investment grade credit risk amid a backdrop where credit quality is expected to deteriorate.

This year we are yet to see a non-call in the hybrids market, though this will likely change as we expect a non-call from a number of REITs and the market looks to have fully priced this in. However, we think investors should view the hybrids sector through two lenses, and separate the REITs from the solid firms who intend to call.