(Bloomberg) -- When CVS Health Corp. sold $3 billion of bonds in early December, it relied on an unusual kind of debt that saw record issuance this year and could set a new high in 2025.
The bonds are known as hybrids, because they have characteristics of both debt and equity. US dollar issuance of the bonds climbed to a record $35.6 billion this year, according to data compiled by Bloomberg that excludes sales from financial companies. That’s up from just $6.5 billion last year.
Strategists at Barclays, focusing on hybrids that mature on a particular date rather than including perpetual securities that are more common among European companies, anticipate sales climbing by about 7% next year to a fresh record.
If a company goes bust, owners of hybrid debt would typically be the lowest priority debt holders in line to get repaid. They’re usually just one step in front of preferred equity holders in line, so ratings firms count the junior subordinated notes as at least partially equity. That allows companies to borrow without having as much of a negative impact on their overall credit ratings.
In February, Moody’s Ratings updated its policies to make it simpler to determine how much of hybrid bond issues to consider as equity. That shift was an “overarching catalyst” for the surge in issuance in the US, according to Meghan Graper, global head of debt capital markets at Barclays.
“That shift in methodology helped to fuel the rebirth of this market,” Graper said. “We think we’re going to continue to see a trend higher in terms of aggregate supply as we move into next year.”
Financial companies have long been big issuers of hybrids, but utilities have been stepping up their sales too, as they raise money to build the power plants necessary for data centers for the artificial intelligence revolution.
Now other companies are jumping in too. CVS this month sold hybrids, its first time selling the securities, and said it was buying back about $1.77 billion of senior unsecured bonds.
The company is trying to fix its balance sheet after years of acquisitions have resulted in a surging debt load and stagnating earnings. Issuing hybrid debt results in a slight decrease in leverage for the company, sending a good message to fixed-income investors, Barclays strategists including Bradford Elliott wrote in a note dated Dec. 13.
“We took a proactive step that reaffirms our commitment to maintaining our current investment grade ratings,” CVS said in response to a request for comment. “The demand for the security demonstrates not only investor belief in our strategy, but also recognition that we have the right plans in place to improve operational performance.”
Investors placed orders for about $17 billion of CVS’s hybrids, according to data compiled by Bloomberg News, signaling strong demand. CVS’s chief financial officer, Thomas Cowhey, said in August that the company is committed to maintaining its current high-grade ratings. On Monday, Moody’s Ratings cut CVS’s main bond grade by one notch to Baa3, or one step above junk, but signaled that the ratings will probably be stable for about 18 months.
Apart from issuers looking to preserve their credit ratings when facing downgrade pressure, hybrid bonds are also ideal for financing construction and investments in capital-intensive sectors like utilities and can be used to fund acquisitions, wrote Barclays’s Elliott and his team.
And while both preferred shares and hybrids can offer equity-like credit, only hybrids allow companies to deduct their regular payments to investors from their income. The CVS hybrid bond sale will probably open the door for other issuers to sell the securities, they wrote.
Tighter spreads compared with senior unsecured funding is also boosting sales, according to an October note from JPMorgan Chase & Co. strategists including Nathaniel Rosenbaum, who anticipate a larger share of the non-bank preferred market to shift to issuing hybrids instead over time. The strategists expect most of this issuance to stem from utilities, communications and consumer discretionary sectors.
“These securities usually go into the main bond indices, which then opens demand up to a much wider universe of potential investors, relative to preferred equity, and that in turn is part of what has driven the spreads on these instruments to be quite tight,” said Rosenbaum in an interview.
Northern Trust Asset Management has been active in financial hybrids, and is looking at deals from industrials and utilities, according to Christian Roth, chief investment officer of global fixed income at the firm. The money manager favors deals from companies with strong credit fundamentals.
“The ability to earn higher yields by being subordinate in a high-grade capital structure is something that’s very attractive as an investor,” said Roth in an interview.
--With assistance from Tasos Vossos.
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