The Long and Short
Verizon shifts to hybrids in cap structure
This material is a Marketing Communication and does not constitute Independent Investment Research.
Verizon Communications (VZ: Baa1/BBB+/A-) made its first foray into the US dollar hybrid market launching two tranches of junior subordinated debt this week. The deal contained new features to entice a broader audience of investors with potential extension risk concerns. While most recent new issues have provided coupon floors, these new structures give issuers further incentives to redeem bonds at the first call date. Revisiting pricing models can help see how the new bonds figure into the landscape and improve security selection across the segment’s various cohorts.
Two hot inflation reports over the past week have contributed to further upward pressure on base rates in recent trading sessions. The conflict in Iran and related oil price spikes have stoked inflation concerns for the past two months, with investors pricing in the higher likelihood of future rate hikes. The environment has had various knock-on effects that require close consideration when valuing callable hybrid securities. More recently, credit spreads have persistently moved tighter, despite ongoing geopolitical and risk and private credit concerns. Similarly, the aggregate spread between junior subordinated hybrid securities to commensurate senior bullet securities has only gotten tighter over the past several months.
With rate uncertainty, non-bank hybrid investors continue to target higher-quality structures featuring either high back-end protection or the coupon floors of newer securities to seek out negative convexity. This continues to create relative value opportunities in some of the more aged vintages, where moderate call protection coincides with the most attractive spread and yield compensation.
Verizon appears to be prioritizing their capital structure with emphasis on hybrid securities while cleaning up some of their older legacy senior unsecured debt obligations through exchange offer. The company has already launched hybrid deals in other currencies. On Monday, VZ priced a $4 billion two-tranche hybrid debt deal: a $2 billion 32NC7 at 6.05% versus initial price talk of 6.50%, and a $2 billion 30NC10 at 6.2% versus IPT of 6.625%. Most issuers opt for a 30NC5 tranche, but VZ appeared to choose the 32NC7 to enhance the duration of 50% equity credit from the rating agencies while also providing investors with a longer fixed-rate period and more spread duration than usual. Instead of a typical coupon floor at the first call date, the 32NC7s contain a +25 bp coupon step in year 12 plus an additional 75 bp in year 27 for +100 bp cumulative. The 30NC10 tranche contains a +25 bp step up in year 10. Both VZ tranches have performed extremely well since launch.
To get a sense of how the market is valuing the new step features, exhibit 1 below presents the new 30NC10 hybrid versus a VZ senior unsecured 10-year bullet. Those bonds are compared with a similarly rated Southern Co (SO: hybrid rating – Baa2/BBB/BBB-) 30NC10 with a coupon floor and a NextEra Energy (NEE: hybrid rating – Baa2/BBB/BBB) with a more onerous back-end floating rate but no floor. The VZ hybrid is currently trading at a roughly +67 bp discount to the VZ 10-year bullet. Meanwhile the SO 30NC10 with a coupon floor is also trading at a commensurate low-70s bp discount to the SO senior bullet (note: one-year difference in final maturity). The more aged NEE 30NC10 with a +245.7 bp back-end and no floor is trading at a little more than 90 bp discount to senior bullets, or about +25 bp discount versus either of the other two structures (note: 2054 maturity). The implication from this small sample set is that the new step features on the VZ bonds are valued similarly to traditional coupon floors, despite providing more incentive to the issuer to call the bonds at first call date. This suggests the new VZ hybrids may be slightly undervalued despite their sharp increase in price in the first week of trading.
Exhibit 1. New VZ 30NC 10 vs Senior 10-year bullets – and comparable NEE relationships
Source: Santander US Capital Markets LLC, Bloomberg/TRACE YAS price indications only
In the two exhibits below, the color scale in the middle indicates how the back-end floating rates compare to the other bonds in group, with the highest spread—affording the most call protection—depicted in green and the lowest in red. Similarly, on the right side of the study, there are another two color scales that depict the spread and yield-to-call picks available relative to senior bullet securities. The greater spread and yield picks are depicted in green with the lower in red. Not surprisingly, higher call protection generally translates to lower spread and yield picks relative to bullets. Please note there are hybrid bonds included in the study that do not have senior comparable securities.
Exhibit 1 lists investment grade non-bank hybrids with roughly 5-year calls (2029-2032) relative to similar 5-year bullet senior securities. This represents the largest segment of the investment grade hybrid universe. Bonds with coupon floors are highlighted in blue and new issues are indicated in gray. Average spread pick for hybrids relative to seniors for this cohort is currently around +120 bp. Aged vintage bonds without call protection that appear attractively valued versus new structures include:
- SRE 6.875% ‘54s (+278.9 bp back-end)
- SRE 6.625% ‘55 (+235.4 bp back-end)
- SRE 6.375% ‘56 (+263.2 bp back-end)
- SWK 6.707% ‘60 (+265.7 bp back-end)
Exhibit 2. 5-year Call IG-Rated Non-Bank Hybrids vs Senior Bullets
Source: Santander US Capital Markets LLC, Bloomberg/TRACE YAS price indications only
The second IG segment in exhibit 2 lists securities with roughly 10-year calls (2034-2036) relative to similar 10-year bullet senior securities. Once again, the recent issues with coupon floors on the back-end are highlighted in blue. Average spread pick for hybrids relative to seniors for this cohort is currently around +75-80 bp. Aged vintage bonds without call protection that appear attractively valued versus new structures include:
- D 6.625% ‘55 (+220.7 bp back-end)
- ENBCN 7.2% ‘54 (+297 bp back-end)
- NEE 6.75% ’54 (+245.7 bp back-end)
Exhibit 3. 10-year Call IG-Rated Non-Bank Hybrids vs Senior Bullets
Source: Santander US Capital Markets LLC, Bloomberg/TRACE YAS price indications only
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