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Unlocking Equity-Like Returns in the Complex Hybrid Segment

Stockholm (HedgeNordic) – Since early 2019, Swedish fixed-income specialist Carlsson Norén Asset Management has managed a fund dedicated to investing in hybrid securities, which combine characteristics of both fixed-income and equity instruments. With five years of track record, Carlsson Norén Yield Opportunity has established a risk-return profile characterized by founder Fredrik Carlsson as “equity-like returns with reduced risk.” During periods of typical volatility and credit spreads, this profile can mirror equity-like returns with volatility levels akin to fixed-income investments.

As with any investment, there is an inherent trade-off between risk and returns. Hybrid securities, ranging from more equity-like preferred stock to corporate hybrid bonds, bank hybrids, and convertibles, typically offer higher yields than traditional fixed-income investments such as corporate bonds. When comparing Carlsson Norén’s portfolio of hybrid securities to the holdings of a traditional high-yield bond fund on the risk spectrum, Carlsson explains that “we prioritize taking more risk at an individual company level by investing in hybrid securities closer to equity risk instead of purely fixed-income investments.” The primary difference, however, lies in the fund’s focus “on investing in hybrids issued by very good companies, while high-yield investing by design involves investing in financially weaker companies,” according to Carlsson.

“We prioritize taking more risk at an individual company level by investing in hybrid securities closer to equity risk instead of purely fixed-income investments.”

“Issuers of high-yield bonds carry poor credit ratings, that’s why their bonds are high yield,” he notes. In contrast, Carlsson Norén Yield Opportunity focuses on investing in the higher-risk, higher-return segments of the capital structure of higher-quality issuers. “We prefer to invest in companies with strong businesses, solid assets, and robust cash flows that can withstand any market conditions,” explains Carlsson. While hybrid securities generally offer greater return potential compared to bonds issued by similarly high-quality issuers, they also come with heightened levels of complexity and risk.

The Complexity

Each hybrid security comes with its own terms and conditions, some of which can span hundreds of pages, requiring expertise to fully comprehend the associated risks and benefits. The expert focused on hybrids within Carlsson Norén Asset Management’s team is Magnus Dahlgren. Despite their varied terms and characteristics, hybrid securities fundamentally blend debt and equity elements. Dahlgren describes these instruments as having bond-like traits, featuring pre-determined coupon payments independent of operational performance, alongside equity-like attributes such as the absence of a maturity date or the potential for conversion into common equities.

“The thing about the hybrid market is that the term sheets can be really, really complicated,” points out Carlsson. “One has to be an advanced investor to be able to assess all the different types of specifics in every issue,” he elaborates. “These term sheets often contain various complexities, such as step-ups if the securities are not called, the optionality related to calls, and many other features. It’s truly complicated at times, requiring thorough scrutiny of all these details.”

“The thing about the hybrid market is that the term sheets can be really, really complicated. One has to be an advanced investor to be able to assess all the different types of specifics in every issue.”

As part of the takeover of Credit Suisse by UBS in early 2022, Swiss financial regulator Finma instructed the credit-stricken bank to write down 16 billion Swiss francs of additional tier-1 (AT1) bonds. Finma’s decision to force losses on AT1 bondholders, while allowing Credit Suisse shareholders to receive small payouts from the takeover put the traditional, common-sense pecking order hierarchy in turmoil. “Investors who do not read terms sheets very carefully may not know that they could lose everything before the equity holders,” reminds Carlsson. “This serves as an example of why it’s crucial to have an experienced fund manager conduct such analysis,” he underscores. “For private individuals or smaller institutions, lacking the time, expertise, and wealth, investing in these types of products is challenging.”

Carlsson Norén Yield Opportunity is designed to provide investors with a diversified portfolio of hybrid securities that may be challenging to access independently. “The fund offers a very interesting portfolio of 35 to 40 holdings in instruments that you cannot access on your own with a reasonable level of confidence, given the complexity of instruments reflected in their term sheets,” emphasizes Carlsson. More importantly, the appeal of different hybrid securities fluctuates across different market environments, further complicating the task of security selection for novice investors.

Property Companies Less Reliant on Hybrids

Companies issue hybrid securities for various reasons, driven either by regulatory requirements or the aim to improve credit ratings as 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. These securities usually constitute the most costly form of debt for an issuer. “Despite higher interest rates associated with hybrids, they can lower the total cost of a company’s debt by facilitating a reduction in the interest rate on senior debt.”

Swedish property companies had been active issuers of hybrid securities in a low-interest-rate environment. “In the past, property companies were in expansion mode and required a strong credit rating to borrow at attractive levels and expand further,” explains Fredrik Carlsson. Since the owners of these companies opted against raising equity to avoid diluting their ownership, they turned to hybrid securities to raise capital while enhancing their credit ratings. “By increasing equity through hybrid instruments, they could get favorable ratings and issue senior bonds at highly attractive rates,” Carlsson notes.

“The property sector is now more focused on divestments or consolidation. The importance of the hybrid market is not there anymore.”

“However, with the significant changes in the market due to rising interest rates, expansion is no longer on the horizon,” he emphasizes. “The property sector is now more focused on divestments or consolidation. The importance of the hybrid market is not there anymore.” While the issuance of hybrid securities from property companies is expected to continue to subside going forward, “there will be a consistent issuance of hybrids in other sectors,” argues Carlsson. Hybrids in the financial sector, for instance, serve as a source of investment ideas for Carlsson Norén Yield Opportunity. Due to regulatory reasons, banks are obligated to issue AT1s, tier 2 and 3 bonds, ensuring a continuous flow of investments in this sector. “We have also seen some issuance in the convertible bond segment, which we have recently participated in, and that is interesting as well.”

“Yields in hybrid securities remain at elevated levels of 12 percent despite the strong rebound in the market, which is much better than expected equity returns in the near term.”

With a 6.8 percent increase in the first quarter of 2024, following a return of 11.3 percent in 2023, Carlsson Norén Yield Opportunity has reached new highs after the drawdown in 2022. Since its launch in early 2019, the fund has delivered an annualized return of 4.5 percent over its five-year journey. Despite the robust performance in 2023 and 2024, the current portfolio of Carlsson Norén Yield Opportunity still benefits from an average yield of 12 percent, with a median of 10 percent across all investments. “Yields in hybrid securities remain at elevated levels of 12 percent despite the strong rebound in the market, which is much better than expected equity returns in the near term,” concludes Carlsson. Carlsson Norén Yield Opportunity remains committed to its objective of generating equity-like returns in the range of 7 to 8 percent with lower volatility than equities over time.

This article is part of HedgeNordic’s Nordic Hedge Fund Industry Report.

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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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