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As bank issuance shrinks, corporate hybrids are in the ascendent, with non-financial corporate hybrids potentially instrumental in powering Australia's energy transition. So what do they offer the fixed income investor?

Australia's hybrid bond market rarely makes headlines, but in recent weeks it has been firmly back in the spotlight. The Australian Prudential Regulation Authority (APRA) recently revealed plans to phase out Australian banks' use of additional tier one (AT1) capital which APRA believes is riskier, thereby seeking to enhance the overall stability of the banking system. The announcement came on the heels of a surge in interest in corporate hybrids sparked by the successful raising for Australian Securities Exchange (ASX) listed mall operator Scentre Group. Yarra's outlook for Australia's hybrid bond market--of which bank AT1 hybrids make up around $41 billion--considers these latest proposed regulatory changes while focusing on the future potential for hybrids in funding corporate Australia's energy transition ambitions.

Investors and issuers alike are now navigating a market partly in transition. More immediately it seems that in the wake of APRA's announcement, some are betting that a shrinking pool of Australian bank hybrids will drive up demand, pushing prices higher and yields lower across Australia's big four banks. Since last month's announcement, spreads for Tier 1 securities have contracted ~16bps--so retail investors are eager to bid up assets and get a larger slice of a shrinking pool.

While uncertainty prevails in hybrid bank issuance for now, and short-term opportunities may arise, over the longer-term a broader set of dynamics is emerging for hybrids, particularly in sectors like energy and infrastructure.

Expanding role in Australia's energy transition

The potential scale of the energy transition in Australia offers an exciting growth opportunity for corporate hybrids. As energy transition projects such as new transmission lines and large-scale generation get underway, hybrids can and should play a role in funding the significant upfront capital costs and become a permanent feature of issuer capital structures.

We estimate a total system investment of $400 billion is required by 2050 in order to decarbonise Australia's energy market with a focus on new energy generation including investment in wind farms, solar, batteries, and associated transmission assets.

It is highly unlikely that equity alone will foot the bill for these expensive projects and that is why we see hybrids as an increasingly popular funding source in Australia's transition to a low-carbon economy, offering flexibility and capital efficiency.

The sheer size of the capital requirement means that corporates will need to tap into multiple funding sources, and hybrids offer a lower-cost alternative to pure equity issuance.

For large-scale energy transition projects, such as new transmission lines and renewable energy facilities, hybrids offer a way to fund significant upfront capital costs without putting undue strain on a company's balance sheet.

For that reason, we expect large blue-chip generation companies like AGL, Origin, APA, and even Woodside and Santos along with transmission companies like Austnet and Transgrid, to tap into hybrid issuance as part of their funding strategies for energy transition plans.

The recent success of Scentre's corporate hybrid raising demonstrates this growing interest from non-financial corporates looking to leverage a flexible funding tool, and we expect this interest to grow from here with further non-financial corporate issuance likely in FY2025.

While APRA's move signals tighter regulatory scrutiny and a potential decline in AT1 hybrid issuance by banks, there is also the possibility that as major bank issuance retreats in APRA's suggested 2027-2032 transition period, corporate issuers may step in to fill the gap.

Bringing it back to fundamentals

As the APRA development demonstrates, assessing and pricing the inherent risks of hybrids becomes trickier with regulatory change in the mix. But these upheavals should be viewed as atypical events in a sector that is actually offering attractive returns akin to longer term equity market averages, with the 'higher for longer' rates, which are thematic for fixed income assets, here to stay.

We are forecasting a new era for tactical fixed income, characterised by sustained, higher yields. In this environment, investors, particularly those focused on investment-grade assets, are increasingly comfortable holding instruments such as hybrids, viewing the attractive yields on offer as ample compensation for assumed risk.

We see further opportunities for investors to access the higher yields and risk-adjusted returns that have made the hybrid instrument so popular recently.

Further, with APRA's decision to phase out AT1 hybrids, there is an expected shift of a substantial pool of capital, estimated to be around $41 billion, that will be seeking new investment avenues. This development is likely to create significant opportunities for corporate hybrids to emerge as a viable alternative for retail investors who are in search of yield. Consequently, we anticipate that corporate hybrid instruments could play a crucial role in filling the gap left by the diminishing bank hybrid market. This shift could potentially lead to a resurgence of hybrid issuance on the ASX, ensuring that investors continue to have access to the attractive yields they have grown accustomed to with bank hybrids, but now through corporate issuance by larger, investment-grade companies.

In addition to the rise of corporate hybrids, another area that warrants close attention as AT1 hybrids are phased out is the potential for Bank Tier 2 paper - that is, subordinated debt which provides an additional layer of protection for banks - to become more prominent on the ASX.

It is conceivable that banks may opt for increased Tier 2 issuance as a strategic move to maintain access to retail capital pools and fulfill their capital requirements while they gradually wind down their AT1 hybrid instruments. This strategic shift towards Tier 2 issuance could provide banks with the necessary flexibility to navigate the changing regulatory landscape and continue to meet their capital needs effectively.

Hybrids in portfolio construction 

A key performance factor here is the issuer's credit strength--when dealing with investment-grade hybrids from strong issuers, the chance of conversion or extension is significantly diminished but investors still get rewarded for taking on what are essentially low-probability events.

These features allow investors to effectively double the credit spread, significantly increasing returns without taking on a disproportionate increase in risk. For instance, investors in Scentre Group's recent hybrid issuance picked up a credit spread that was 1.8 to 1.9 times the spread on the company's senior debt, providing a return close to 6%.

Chart 1: Scentre Group Bond Curve - 4 September 2024

Source: YCM, Oct 2024.

 

Myths about hybrids

There are several misconceptions about hybrid securities that often lead to a misunderstanding of their risk and reward profile, particularly among investors who may equate them with pure equity. One common myth is that hybrid bonds are simply 'equity in disguise'. While hybrids can have equity-like features, particularly in times of financial stress, as mentioned their risk-reward profile more closely tracks the underlying credit quality of the issuer.

Provided you are investing in high-quality issuers the likelihood of hybrids not being refinanced at their call (redemption) dates or experiencing write-downs should be quite low.

This is why, despite these structural complexities, we believe hybrids offer compelling risk-adjusted returns over both the short and long term. Their attractive yields compensate investors for these theoretical risks, while the actual occurrence of negative outcomes remains infrequent.

This dynamic has made hybrids a popular choice among sophisticated fixed income investors seeking higher returns without assuming the full risk profile of equity.

An elegant solution for balancing capital needs and sustainability goals

For corporate issuers, hybrids offer a number of attractive properties, particularly if a company is looking to fund expensive infrastructure development, mergers and acquisitions, raise capital without having to sell assets, or strengthen their balance sheet.

Because of their 'hybrid' nature--whereby half of the amount on issuance is counted as equity and, therefore, not included in that gearing calculation--hybrids can be a great source of capital flexibility. This can mean the ability to run a little bit more debt, negate the need for asset sales, optimise the amount of equity capital, or support and protect a credit rating.

These useful features make them relatively more appealing as a funding instrument for utilities and other infrastructure providers where capital is intensive and locked into large-scale projects with long-term build horizons. That is why we expect hybrids to feature more prominently in Australia's utilities sector, providing flexible capital sources for the energy transition build, including both for renewable energy infrastructure and energy transition infrastructure.

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The "Trump Bump" in full effect, with bitcoin not the greatest benficiary and fund managers allocating away from equities beforehand; the "Super Bump" in Australian equities, as evident in the P/E multiple of CBA; gold's correlation; subsea cable spend creating opportunities; funds flowing out of Chinese investment markets; the boom in private equities and the truth about volatility; and finally the inflation story is not over yet in the US.

Benchmark returns in the week of the US Presidential election (Nov 4 - 8, 2024)

Source: Equitable Investors' SmallTalk

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"Trump Bump" for NYSE-listed "closed end" SpaceX investor Destiny Tech100 (DXYZ) outshines bitcoin

Source: Koyfin

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Second largest net sale by institutional clients in Bank of America fund manager survey history

Source: Bank of America

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"Super Bump" for Australian equities

Source: Evans & Partners

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Forward P/E multiple of Commonwealth Bank (ASX: CBA)

Source: TIKR

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Correlations between gold and other assets classes over past six years

Source: World Gold Council

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Rolling 6 month correlation between gold and other asset classes

Source: World Gold Council

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Regional subsea cables being built

Source: DXN Limited

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Forecast spend on submarine cables

Source: Research & Markets

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S&P 500 forward 12-month P/E ratio: 25 years

Source: FactSet

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Foreign investment into China drops in 2024

Source: @Kobeissiletter, China's State Administration of Foreign Exchange

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Global private equity assets under management

Source: Bloomberg, Bain & Co

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The reported volatility of private funds v "unsmoothed" volatility

 

Source: Bloomberg, "Amortizing Volatility across Private Capital Investments" (Mark Anson, The Journal of Portfolio Management, Vol 50, Issue 7)

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US Core CPI Inflation (year-on-year % change) - consecutive months above 3% (seasonally adjusted)

Source: @CharlieBilello, Creative Planning

November 2024 Edition

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What is the issue?

Donald Trump is not known for being progressive on sustainability issues. He has previously promised to withdraw US participation in the Paris climate accord. But in terms of markets, what are the potential implications across sustainability themes from his second term in office? 

Climate

There have been concerns that the Inflation Reduction Act (IRA) will be one of the first things to go. But we don't expect a full repeal; reforms are most likely. This is partially because the IRA mainly benefited red states (see below). It's also because Trump is pro-energy and investment, but he's agnostic on the energy source. He has pledged to increase oil and gas licences on federal land, which could happen quickly through an executive order. This also increased under Biden, but the rate is likely to accelerate. 

Investment in clean tech by voting district* during the Biden Harris Administration as of 10.31.24

$42B - Democratic districts | $161B - Republican districts

Source: Bloomberg Opinion Article, Biden Is Giving Red Districts an Inconvenient Gift: Green Jobs, Published June 20, 2024, accessed 06/04/2024.

 

*Colour represents the voting of the 2022 House Representatives Elections.

Investment in Republican (red) and Democratic (blue) districts pre and post the Inflation Reduction Act

We expect that the US will withdraw from the Paris climate accord again. This won't happen at COP29 next week, but it will likely affect the US's ambition at the talks. 

During his campaign, Trump promised to end the "EV (electric vehicles) mandate", even though no such federal mandate exists [1]. We think a rollback of Biden's pro-EV policies, including sections of the IRA that incentivise EV production and adoption, are likely. On the surface, this would be potentially negative for his strong supporter Elon Musk who owns Tesla. Tesla's scale and scope could be an advantage over other EV producers if subsidies were removed. Tesla's stock was up almost 15% on Wednesday 6 November. 

Reforms to the IRA we think are likely:

More likely to stay intact	Less likely to stay intact
• Domestic-critical, mineral-processing support	• EV consumer sales credits (who is chosen on the administration will be important here)
• Clean-energy manufacturing tax credit, and renewable-energy production tax credits	• Environmental Protection Agency's (EPA) auto greenhouse gas targets
• Nuclear energy tax credits	• Residential clean-energy efficiency credits (e.g. heat pumps)
• Under a full US IRA repeal scenario, projects under construction are likely to be granted safe harbour to secure tax credits	• Methane leakage fines
	• Clean hydrogen production and carbon capture storage tax credits*
	• Sustainable aviation fuel credits

*This one is highly complex and could go either way. On one side, continued funding will be highly lobbied by the energy sector. But on the other, Trump is not pro big-government and large tax-payer-funded projects, especially those with low technology readiness. Therefore, we are cautious. However, the funding mechanism that flows through the EPA could become an issue. As the agency's funding is likely to be cut significantly, this will make the final distribution of the funding slow.

We also expect increased tariffs on imported clean tech (especially EVs), but not at the level Trump has stated.

Nature 

The Biden administration strengthened several nature-related regulations, like the Endangered Species Act, and pollution regulations. These should be safe in the short term, as they are unlikely to be an initial focus area. But the likely defunding of the EPA will take the teeth out of the regulations. Alongside the overturning of the Chevron deference (which gave federal agencies powers to interpret laws and decide the best ways to apply them), this will severely weaken the powers of the EPA.
One area that benefited under the last Trump administration was the superfund (the fund set up to help remediate the nation's worst polluted areas). There are clean-tech names working in remediation that could benefit, such as Tetra Tech, if a similar thing happens in his second term.

Social

This could become challenging for corporations, as they were previously pressured by employees to make statements opposing government stances during Trump's first administration. Diversity, equity and inclusion are likely to be at risk. Investors looking for greater transparency and action are also likely to face increased scrutiny.

Abortion rights were a key campaign topic, but this was more likely to see change under a Harris administration. Given the Republican win, the dynamics of the Supreme Court, and Trump's stated view that abortion rights should be decided on at a state level, we don't expect federal changes. Additional states might implement bans that could lead to repercussions for women's health and wellbeing, and their productivity in the workforce. Interestingly, abortion protections were on the ballots at this election and in many states these passed. Investee companies have faced pressure via resolutions tabled at annual general meetings (AGMs) to refuse employee healthcare benefits to those seeking abortion.

A unified Republican Congress is likely to pass the H.R 2 bill. This would require employers to verify whether employees have the legal right to work in the US. If passed, the bill is likely to reduce the undocumented workforce and the flow of new arrivals into the US. It's therefore probable that the migrant workforce will be smaller under Trump, resulting in a negative shock to the labour market.

Governance

This year, the Securities and Exchange Commission (SEC) introduced new rules mandating company disclosures on climate-related risks. Under a new Republican SEC chair, we expect these requirements to be removed. The SEC also eased restrictions on resolutions at AGMs, leading to a surge in proposals advocating for environmental, social and governance (ESG) issues - particularly climate and employee rights. This has been met with 'anti-ESG' resolutions questioning the allocation of resources to ESG matters and political advocacy, such as women's health rights. The new rules were not unanimously supported and could be reversed, potentially resulting in a rise of 'anti-ESG' resolutions at AGMs. We do not anticipate significant changes to board standards.

Final thoughts

The initial reactions affecting clean-tech stocks are subtle. The trajectory and implications for sustainability and specific stocks will become clearer once the administration's nominations are announced. 

 

Author: Ann Meoni, Senior Sustainable Investment Manager
Nick Gaskell, Sustainable Investment Manager
Nancy Hardie, Sustainable Investment Analyst
Andrew Mason, Head of Active Ownership

¹https://www.factcheck.org/2023/10/trumps-misleading-claims-about-electric-vehicles-and-the-auto-industry/

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