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European corporate hybrid bonds: A bull market trade gone wrong?

Corporate hybrid bonds are living up to expectations of poor performance in a bearish market.

European corporate hybrid bonds have performed disastrously of late. They heavily underperformed the market during June. The spread widening varied anywhere between 30 and 100 basis points. For instance, Bayer’s hybrid security moved out to 320bp over swaps from 245p in three weeks. The scale of the demise is even more marked if the full six months of the year is taken into account. In January this deal was quoted at 175bp.

During the past two months a risk premium has returned to the market. There appears to be a general unwind taking place, with a reduction of leverage and exposure to the riskiest asset classes, such as corporate hybrids. We have argued before (Euromoney, March 2006, “Hybrids not all they are dressed up to be”) that this was a classic bull market trade. They would perform fine when the market was roaring in the right direction but what happens when the credit cycle turns? Recent equity weakness helps explain widening in high beta credit product, but doesn’t tell the whole story on corporate hybrids.

Although bank and insurance tier 1 has also suffered, there are several reasons for this; like a lot of new issues but also regulatory woes in the US and resultant fears of extra supply.

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