Green hybrids – a win-win solution?

24 Feb 2023 . 4 min read

Whilst still a relatively new phenomenon, one in every six corporate hybrids is now in green or sustainable format[1]. Issuance so far this year has, for example, included transactions from Red Eléctrica and Telefónica, which have been well received in the market.

[1] As of February 2023, ~EUR 30bn of European corporate hybrids outstanding are in GSS format out of a total hybrid market of ~EUR 200bn.

Chart 1: European corporate hybrid issuance in green or sustainable format

Source: Dealogic, as of 3 February 2023.

So, what explains the rise of this asset class? There are a number of reasons:

A compelling financing option for issuers

As companies shore up their balance sheets and accelerate their transition plans, hybrids have proven to be a compelling option for corporate treasurers: while moving their asset base to a more sustainable footing, a green perpetual instrument is seen as aligned with this strategic shift (some firms have even done green “pure” equity). This is particularly true for asset-rich companies, such as utilities, telecom and real estate firms.

(Green) hybrid refinancing now more common in Europe’s bond market

Stable market windows and supportive investor sentiment have provided the opportunity for hybrid refinancing (which are typically expected to be redeemed at their first call date), with various types of green tender and new issue operations now more common, which offer added flexibility for issuers.

Conventional-into-green hybrid refinancing entered the market in January 2018 when Engie successfully executed (led by NatWest) this type of transaction, while more recently green-into-green hybrid refinancing has also gained popularity (e.g. Energias de Portugal).

Higher yields provide an opportunity for more pronounced greeniums and market access

The high-beta nature of the hybrid asset class, and higher all-in yields, can deliver a more pronounced greenium and improved market access for new issues, which provides an opportunity for corporates to capitalise on ESG-labelled instruments. Although all hybrid transactions in 2023 so far were oversubscribed, green hybrid issues had a higher average oversubscription of 7.3x (at final terms) vs. 6.4x for non-green hybrids.

Opportunity for investors to construct more diversified portfolios

For impact investors and accounts seeking to be overweight in Green, Social & Sustainability (GSS) bonds, hybrids can be a valuable portfolio addition as they offer a helpful yield pickup in a market still dominated by lower beta and investment grade supply, allowing them to construct more balanced investment portfolios. In addition, some have argued that offering “risk” capital for green investment is also a strong incentive to support companies’ long-term environmental plans.

Common feedback from investors on the green hybrid structure include:

Green hybrids are relatively rare, hence – given that certain funds prefer green assets – there should be more demand for a green hybrid
Some investors are indifferent to the green nature of the instrument, while others prefer for the bond to feature any type of sustainability element (e.g. green use of proceeds or sustainability-linked bond)

Rating agencies and other regulatory bodies remain constructive

The main credit rating agencies – Moody’s, S&P and Fitch – have never treated green (or sustainable or social) use of proceeds hybrids differently from regular (non-green) hybrids. They typically assign the same (50%) equity credit and issue rating to the instrument, which gives corporate treasurers the flexibility to select the most suitable financing instrument for their needs. Similarly, we are not aware of any different treatment of green hybrid bonds from an accounting, legal or tax perspective (over and above the use of proceeds considerations).

However, sustainability-linked structures have proven to be subject to more constraints in the hybrid market, and there have been no precedents from rated issuers yet (see our Insights hub for previous articles on this topic).

Market authorities accept perpetual securities

The International Capital Market Association (ICMA) has indicated that green perpetual (callable) bonds are acceptable if they contribute to environmental objectives by exclusively applying the proceeds to finance or re-finance eligible Green Projects and if they align with the Principles Core Components. As in any other type of GSS labelled products, issuers should place adequate emphasis on their post-issuance reporting.

To each their own

In short, green corporate hybrids can offer something for each of the key market participants. Over time, innovative sustainability-linked hybrid structures may also enter the market – similar to innovations seen in other forms of green equity-like structures, such as convertible bonds. What is clear is that the carbon transition requires support across the capital structure, with new and untested technologies in particular requiring “risk capital”. Hence further green hybrid supply is to be encouraged.

From our side, we will continue to support this asset class. NatWest is a leading bank in European hybrids, in both primary and secondary markets, as shown by our involvement in new issuances, our publications and our active secondary trading desk.

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