Investors pounce on ‘once-in-a-decade’ deals in European real estate bonds

Credit investors believe they have found a “once-in-a-decade” deal in the battered bonds of European residential real estate companies, which are now on the rise.

Fund managers including UBS and Schroders are among those who have bought so-called hybrid bonds of real estate companies, hoping to profit from falling interest rates as some of these companies raise fresh capital to ease cash flows over time short.

Hybrid bonds are riskier junior debt with no maturity date and were readily issued by real estate developers looking to shore up their balance sheets when borrowing costs were low.

Credit agencies typically treat them as part equity and part debt, meaning they only partially add to a company’s debt load.

The price of these bonds fell in 2022 as central banks quickly tightened monetary policy to combat runaway inflation, with some of the most aggressive and indebted developers particularly hard hit. Some issuers also angered investors by not buying back debt at par after prices fell.

But with the European Central Bank now cutting interest rates again, renewed demand for housing debt is turbo-charging riskier debt such as hybrids, credit strategists and investors say.

“This was a once-in-a-decade trading opportunity” for credit investors, said Zac Swabe, lead portfolio manager for European High Yield at UBS Asset Management.

European real estate bonds make up the bulk of his portfolio, with hybrids being the best performers, and he’s holding onto them in hopes of further gains.

Among the bonds in the sector that have performed strongly this year are three hybrids issued by indebted Swedish developer SBB (Samhällsbyggnadsbolaget), which have almost tripled in price this year.

The price of a bond issued by Luxembourg-based CPI Property Group has doubled in price.

Some of this debt, such as the Aroundtown 3.375% hybrid, offers better yields than other risky securities. That has helped boost performance this year as investors seek to lock in yields as the European Central Bank cuts borrowing costs and boosts some fund managers’ portfolios.

“I like to think it’s a reverse Minsky moment,” said Hugo Squire, high yield portfolio manager at Schroders, referring to the name given to sudden market collapses caused by a period of speculative activity.

“You either owned enough of these (real estate) names or you fell behind your peers,” Squire said. “Real estate hybrids are an important factor in the (broad distribution) of returns among European high-yield funds.”

Squire bought into the sector about 18 months ago when risk was rising and property hybrid prices had collapsed to around 30-40 cents to the euro.

At the time, residential property issuers largely decided not to accept an industry-standard option known as a bond call. While hybrids are typically perpetual, this option allows them to return principal to bondholders and refinance with fresh capital.

However, the cash crunch in the sector has discouraged most from doing so. In a number of cases, such as Aroundtown in January 2023, this has irritated bondholders and damaged the reputation of some issuers.

The rise in European property bonds also comes after a series of governance scandals previously spooked investors in the sector, with serious accounting problems at German owner Adler roiling the wider market in 2022.

SBB and CPI have both come under scrutiny from short sellers.

CPI bonds rose earlier this month after an investigation by law firm White & Case “rebutted” allegations of financial impropriety made by US short seller Muddy Waters, but still recommended “greater separation” between the property firm and her family office. founder.

Less than two years after the crisis, many real estate companies found themselves in favor of credit investors.

“There is a lot more appetite for these instruments from investors now,” said James Vokins, global head of investment credit at Aviva Investors. He believes the investor base for these subordinated bonds has widened since last year. “They are seen as . . . a little extra juice for the portfolio.”

But he added that real estate hybrids had become a “consensus” position for credit investors and said “longer term we are cautious about them. You don’t get paid for . . . risk (added) to current prices.”

Others, such as Julian Marks of Nomura Asset Management in London, warn that prices may not have much to go.

He bought some of those real estate hybrids in late 2023, but said companies like Aroundtown suffered some reputational damage for not filing for bonds last year.

He also believes that many of these businesses are still struggling with large amounts of debt against the still volatile local property markets in Central and Eastern Europe.

“Not all real estate issuers are out of the woods right now,” Marks said. “They’re still counting on interest rates going down rather than improving (cash flow) for them.”

But for now, investor demand remains firm for any high-yield hybrid real estate issue, should they decide to refinance, according to Henry Holden, executive director of European debt syndicates at Goldman Sachs.

“High quality real estate companies can issue new hybrids now, there is enough demand.”

Additional reporting by Robert Smith