NEW YORK (MarketWatch) -- With the investment-grade corporate bond market still in fine fettle and regulatory challenges out of the way, U.S. hybrid securities, which blend equity and debt characteristics, have been producing beefy valuations for investors.
While that's good news for those who held onto their hybrids since last year, newcomers might not find similar appetizing opportunities this year. The outlook is not all bright skies for the market; given that many of the issuers in this sector come from the mortgage finance industry, subprime borrowers' recent woes could yet spell trouble for the hybrid market.
For sure, investors who held onto their hybrids as these fairly new products ran into regulatory squalls last year have already proven they have strong nerves.
Roughly a year ago, Wachovia Corp. (WB), one of the first to sell a hybrid offering, issued 5.8% hybrid notes due 2011 at 142 basis points over Treasurys. The bonds came under heavy pressure in the spring and summer and at their widest traded out to 154 basis points over Treasurys in August.
That's because a commission of insurance regulators - the National Association of Insurance Commissioners - unexpectedly categorized hybrid securities as stock instead of debt, making it more expensive for insurance companies to invest in them and cutting demand.
The matter was settled in September when the NAIC decided to classify hybrids as preferred stock at least in the short term, in line with the approach adopted by the ratings industry.
Wachovia's notes traded as tight as 71 basis points over Treasurys Feb. 2 and around 76 basis points Tuesday, a whopping 66 basis points tighter than where they initially priced.
American Express Co. (AXP)'s 6.8% bonds of 2016, sold in the midst of the NAIC uncertainty, have tightened even more significantly.
The bonds traded at 101 basis points over Treasurys on Jan. 29, 80 basis points tighter than where they initially priced. They are currently trading around 103 basis points.
Risk & Reward
To be fair, not all hybrids have seen such a dramatic rally. Overall, risk premiums on U.S. hybrids tightened by 29 basis points on average in 2006, according to Ricardo Kleinbaum, director and credit analyst with BNP Paribas.
But "they all continue to do better," said Wayne Schmidt, senior portfolio manager at AXA Investment Management.
Although it was seen as risky to own hybrid securities for most of last year due the uncertainty surrounding the NAIC, investors who held onto them during the turmoil are now being rewarded.
"The NAIC comments did create uncertainty and that uncertainty did create opportunities at that point in time," Schmidt said. "People who took that opportunity got rewarded."
The main driver behind the gains has been the general robust tone of the investment-grade corporate credit market, where perception of risk has been almost inexistent for months.
Leveraged buyouts that endanger credit quality haven't worried hybrid holders either - in fact, investors have found shelter in these securities as they are mostly issued by financial services companies which are out of reach of private equity firms. "There's little LBO risk if any," Kleinbaum said.
Market participants were also fearing some downgrades of hybrids by Moody's Investors to reflect the possibility that interest payments can be delayed without triggering a default by the issuer. But that proposal was dropped at the beginning of the month after negative market reaction.
And with risk premiums on investment-grade corporate bonds still at historically narrow levels, hybrid securities are providing some extra yield for investors compared with plain-vanilla bonds as they are more subordinated than traditional bank notes. That has attracted investors such as hedge funds, which typically don't invest in financial service company bonds.
Still, it would be perhaps foolhardy to talk of plain sailing ahead for this sector as its next challenge is already looming. Though the subprime mortgage market woes have yet to hit investment-grade corporate bonds, hybrids could be vulnerable because many issuers are in this sector. Countrywide Financial Corp. (CFC), for example, sold a $1.3 billion hybrid late last year.
Any volatility, though, could create the next buying opportunity, said Kleinbaum, who doesn't see the subprime problems as a threat to hybrids.
In fact, he thinks hybrids are in for a longer smooth ride. "This year, you're not going to see that kind of volatility" seen last year, he said.
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