This article originally appeared in efinancialnews.com on 11 May 2015.

I 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 you buy?”

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 steeply.

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 less.

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.

Transatlantic shadow
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 structure.

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.

The Author

Andrew Bosomworth

Head of Portfolio Management, Germany

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Disclosures

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Hybrid securities have certain risks in common with other fixed-income securities, including market, interest rate, issuer, credit, liquidity and default risk as well as are subject to event, deferral and call or reinvestment risk. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2015, PIMCO