This article originally appeared in
on 11 May 2015.
t is a simple question, but has perhaps never been so difficult to answer: “If you could choose only equities or bonds,” I was asked recently, “what would
For investors in Europe, the question is especially tricky. Bonds are near record low yields. Equities are more volatile and prices have already gone up
So, bonds or equities? I am not trying to be evasive if I reply: “Both.” Nor am I trying to be contrarian if I suggest that, despite banks’ protracted
difficulties since the credit crunch, they are issuing one of the most enticing investments in Europe at the moment.
Some market statistics will make the European investor’s dilemma clear. Barclays Euro Aggregate index, a broad index representative of the European
investment grade bond market, yields just 0.78%, as of last week. On 69% of the securities in it, the yields are 1% or less and, on 14%, they are zero or
In the absence of deflation, zero and negative interest rates transfer wealth from creditors to debtors and from traditional safe havens to riskier assets.
The arithmetic of low interest rates and discounted cash flows represents a promising investment thesis for equities. Low interest rates raise the present
value of future dividends and, therefore, today’s equity prices.
At about 3,600 points currently, Europe’s blue-chip equity index Euro Stoxx 50 would have to rise nearly 50% to reach its peak, set 15 years ago.
Comparable indexes in the U.S. have surpassed those dotcom-era levels already, suggesting further upside potential in Europe. And with a dividend yield of
3.3% on Euro Stoxx 50, equities appear to be an easy choice over bonds.
But equities are more volatile than bonds and valued at almost 22 times earnings, the Euro Stoxx 50 is no longer cheap. The cyclically adjusted
price/earnings ratio of companies in the U.S., known as the CAPE ratio, casts a shadow over Europe. CAPE is defined as the share price divided by the
average of 10 years of earnings, adjusted for inflation. The CAPE ratio on the S&P 500 Index, developed by Professor Robert Shiller and calculated by
Yale University, is 27 times earnings and was only higher than today’s level for a few months in 1929 and from 1996 to 2000 in the run-up to the dotcom
bubble, the period described by then-Federal Reserve (Fed) chairman Alan Greenspan as “irrational exuberance.” If U.S. equities were to tumble, so the
argument goes – for example, because the Fed hikes interest rates – European equities might follow.
Hence the difficulty of the question “bonds or equities?” – but what allows me to answer it “both” is the existence of hybrid securities. As their name
suggests, hybrid securities blend the characteristics of bonds and equities. Like bonds, hybrids typically pay fixed coupons, but the coupons and yields
are generally higher than those on senior unsecured bonds owing to, as with equities, greater risks. Most hybrids currently yield between 2.5% and 6.5%,
depending on maturity, issuer and structure.
Hybrids’ dividend-like coupons are matched with equity-lite risks, such as less volatility, which derive from their rank in a company’s capital structure.
Hybrids are junior to senior unsecured debt, which has a priority claim over assets in the event of bankruptcy. But principal and coupons on hybrids rank
senior to common equity. Some hybrids are genuinely perpetual, while others have long legal maturities, up to 50 years or longer. Hybrids often contain
calls exercisable by the issuer after a given period, such as five or 10 years. This option increases yield relative to non-callable bonds.
Some hybrid structures allow issuers to skip coupons completely. Other structures allow issuers to defer coupon payments – for example, if the company’s
capital ratio falls below a regulatory threshold – while coupons on yet other structures are non-deferrable. Deferred coupons can be cumulative or
non-cumulative, and non-payment or deferral of coupons typically does not constitute an event of default; it depends on each individual security’s
Both banks and non-financial companies issue hybrids. Hybrid securities issued by non-financial companies are fairly standardised. It is the banking sector
that is the most prolific producer of innovation and variety. Required by regulators to raise capital ratios, banks are seeing a quiet revolution taking
place in the composition of their balance sheets that offers investors interesting opportunities. Banks globally are deleveraging to comply with widespread
regulatory reform, which should lead to fewer bank failures in the future due to stronger capital buffers.
Global banks are operating at multi-decade-high levels of capital with core Tier 1 ratios of 8% to 12%, well above the 7% minimum capital ratio requested
by Basel III regulation. Although most global banks hold ample core Tier 1 capital, Basel III introduced an additional 3% leverage ratio that takes into
account a bank’s total assets. Basel III also requires banks to hold a certain amount of their own hybrids to strengthen their loss-absorbing capacity.
Spot the dislocation
As a consequence, more issuance of contingent convertible capital notes (CoCos) and Tier 1 notes, specific types of hybrid securities, can be expected from
European banks in particular. Bank of America Merrill Lynch’s Contingent Capital index now contains $130 billion face value in securities outstanding, up
from $50 billion two years ago, and we expect the market to grow significantly by the end of this decade.
As is often the case with newly developing markets, dislocations in the relative value pricing of companies’ capital structures persists, offering
attractive active management opportunities.
Subordination premiums, particularly in the global banking sector, remain abnormally elevated in the context of rapidly improving credit metrics, with
differentiation among senior and subordinated bonds and equity pronounced. Geographical dislocations in companies’ capital structures also persist.
Valuations in select hybrid bonds remain attractive relative to traditional investment grade, high yield and common equity securities.
Stress-testing companies’ abilities to absorb losses on their business models is an integral component of investing in hybrid securities, as is marrying
top-down country-level macro risks with bottom-up company specifics in light of individual security valuations. Hybrid securities breathe with the stock
market, displaying positive correlations of returns to equity and high yield bonds and negative correlation to high quality government bonds. While hybrids
are not for the faint-hearted, if you are ever asked that question – equities or bonds – consider hybrids, the asset class in between.