As inflation rises, are hybrids the answer?

Following Brexit, one of the main consequences appears to be an increase in inflation due in part to a falling pound. One firm suggests that hybrid bonds are best suited to this market.

Peter Doherty, chief investment officer of UK-based Tideway Asset Management, told Funds Europe that hybrid bonds can be described as “the cheapest house on the most expensive street”.

Large household names like Sainsbury’s issue them, the bonds have characteristics of both debt and equity and are used to raise funds without diluting common equity holders. The bonds rank ahead of equity but are subordinate to other debt securities.

Sainsbury’s issued a hybrid bond last year with a 6.5% yield, callable in 2020. Doherty said he would not buy Sainsbury’s equity because the company’s in a highly competitive market, it’s a low margin business as well as having a substantial pension deficit.

“[With hybrids] You have to ask yourself a different question. Not is it going to be a great growth story, [rather] is it going to remain in business amd are they going to meet their obligations? It’s a lower barrier,” said Doherty.

Doherty is keen to stress the difference between hybrids and high yield bonds despite the similar yields. He says that high street retailer New Look issued a senior high yield bond at the same time Sainsbury’s issued its hybrid, with the same coupon that reaches maturity in 2022.

“New Look is a much more risky prospect  – weaker balance sheet, less stable earnings and operating in a very transient market,” says Doherty.

The CIO of the £150 million (€168 million) asset manager makes a compelling case for hybrid bonds in the current market. With inflation running at around 1% if you invest in UK government bonds (gilts), after three years you are guaranteed negative returns according to Doherty.

Hybrid returns tend to be mid single digit, they have a flexible investment horizon from six months to 20 years and aids diversification away from equity income and low returning bonds.

Tideway recently won a £20 million corporate pension mandate and Doherty predicts that his recently launched hybrid fund could reach £1 billion in assets.  However, his firm faces stiff competition from larger players such as Fidelity, which launched its own hybrid bond fund last year.

©2016 funds europe

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