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The Road Less Traveled: The Space Between Bonds and Equities

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Stockholm (HedgeNordic) – Fixed-income boutique Carlsson Norén Asset Management runs a distinctive fund that focuses on the spectrum between senior bonds and equities. This particular space encompasses a variety of financial instruments, spanning from senior bonds at the lower-risk, higher-priority end of the spectrum to equity-like instruments such as preference shares or D shares, which carry greater risk and lower priority.

The current portfolio of Carlsson Norén Yield Opportunity boasts a yield-to-call of between 14 and 15 percent, all without venturing too deeply into high-risk territory. “This is an opportunistic fund that can invest in the entire space between senior bonds and equity, starting from the higher-priority senior bonds, then hybrid bonds and extending to the lower-priority instruments such as preference shares and D shares,” explains portfolio manager Magnus Dahlgren. The majority of the fund’s exposure is in corporate hybrids and bank hybrids, with a growing exposure to senior bonds at the expense of riskier investments such as preference shares.

“This is an opportunistic fund that can invest in the entire space between senior bonds and equity…”

“Senior bonds are not necessarily the main focus of the fund, but we have seen very attractive opportunities in this space, especially when comparing to D shares and preference shares in the real estate sector,” highlights Dahlgren. Some issuers of preference shares from the Swedish real estate sector are likely to cut their dividends to strengthen their financial position in an environment of higher interest rates. “This universe is not investible for us at the moment because of the low expected rate of return over the long term,” explains Dahlgren.

Conversely, real estate companies unlikely to cut their dividends on preference shares are currently trading at yields ranging from seven to nine percent, placing them in the same range as their senior bonds. “For that reason, we prefer the senior bonds because they have a much higher priority and lower risk with a similar expected return,” argues Dahlgren. “This will probably change back and we are looking for opportunities to switch back into more equity-like instruments in a couple of years.”

Back to the Basics

While subject to diverse terms and characteristics, hybrid securities fundamentally encompass both debt and equity elements. Dahlgren describes these instruments as having bond-like traits, featuring pre-determined coupon payments independent of operational performance, along with equity-like attributes such as the absence of a maturity date. Although hybrids are perpetual, they become callable several years after issuance, often at the five-year mark. “Most hybrid securities are perpetual, but in reality, the duration is much shorter because the instruments are callable,” says Dahlgren.

“Despite higher interest rates, hybrids can lower the total cost of a company’s debt by enabling a reduction in the interest rate on senior debt.”

Companies issue hybrids for various reasons, whether driven by regulatory requirements or the desire to improve their credit ratings, given that hybrids carry a partial equity component. “Hybrids are considered part equity by credit rating agencies and can be valuable for companies in strengthening their rating,” explains Dahlgren. “Despite higher interest rates, hybrids can lower the total cost of a company’s debt by enabling a reduction in the interest rate on senior debt.” These securities usually represent the most expensive form of debt for an issuer.

Emerging from Turbulent Times

The financial and real estate sectors naturally witness higher issuance of hybrid securities, which explains the elevated volatility in the Nordic universe of hybrid securities throughout 2022. With real estate companies grappling with increased inflation and higher interest rates, the more junior hybrid securities bore the brunt of heightened uncertainty. The banking sector also experienced turbulence, stemming from the takeover of Credit Suisse by UBS. The Swiss financial regulator mandated the credit-stricken bank to write down additional tier-1 (AT1) bonds, while equity shareholders received payouts from the takeover, leading to a disruption of the traditional pecking order hierarchy.

“As a general rule, hybrids are not very sensitive to interest rates, but they are more sensitive to the risk sentiment in the market.”

“As a general rule, hybrids are not very sensitive to interest rates, but they are more sensitive to the risk sentiment in the market,” explains Dahlgren. The unique situation in the Swedish market stemmed from the substantial presence of corporate hybrids within the real estate sector. For issuers of hybrids in other business sectors, “hybrids are not very sensitive to interest rates,” according to Dahlgren. Most hybrids, at least in the Swedish market, take the form of floating-rate notes and are not significantly affected by interest levels at all, except for increased coupon payments.

Despite significant turbulence and uncertainty, Carlsson Norén Yield Opportunity emerged from the turmoil with a loss of 13.6 percent in 2022. The fund has already gained close to seven percent in the first ten months of 2023, all while still enjoying a yield-to-call in the range of 14 to 15 percent. “Although there’s been turbulence, the fund has managed to navigate this environment very well and the future now looks promising,” Carlsson summarizes last year’s turmoil. “We have weathered these storms tremendously well, avoided troubled companies, and prevented permanent capital loss.”

“Hybrid securities were yielding around five or six percent a couple of years ago. But now, you can get 15 percent.”

The switch from equity-like instruments to senior bonds saved a lot of money for Carlsson Norén Yield Opportunity, but its portfolio was still affected by the volatility in the market. “There were no credit events, it was simply price volatility,” says Dahlgren. “We navigated through this turbulence effectively, and with interest rates significantly higher now than a few years ago, along with much higher risk premiums, this creates really good opportunities for long-term investors,” adds the fund’s responsible portfolio manager. “Hybrid securities were yielding around five or six percent a couple of years ago. But now, you can get 15 percent.”

The Opportunity Ahead

As fixed-income macro managers, the team at Carlsson Norén Asset Management holds a well-documented view of where interest rates are headed. They anticipate that rates will decline in the future, particularly benefiting hybrid instruments in the property sector, which “have been hammered during the rise of the interest rates,” according to Carlsson. “Having investments in hybrids tied to the property market is advantageous if interest rates come down because lower rates will be good for the bonds, good for risk premiums, and also good for the property sector.”

“I have never seen such a big advantage for hybrids compared to equity investments in the same businesses.”

Return expectations for Carlsson Norén Yield Opportunity largely hinge on risk sentiment, which, in turn, depends on the development of inflation and interest rates. Dahlgren suggests that expecting at least ten percent annually over the next couple of years is a reasonable projection. Although Carlsson Norén Yield Opportunity seeks to represent an alternative to funds in the fixed-income space, Fredrik Carlsson also observes that hybrid securities offer much higher potential compared to equity investments of the same issuer.

“I have never seen such a big advantage for hybrids compared to equity investments in the same businesses.” Carlsson points out that the expected return on the stock market typically involves a risk premium of around four percent, translating into an expected return in the range of seven to ten percent. “In the hybrid market, you get a much higher expected return than the equity market at the moment.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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