A hybrids game changer

Investors in corporate hybrids may have to play by a new set of rules … and it could get nasty.

PORTFOLIO POINT: Planned changes on hybrid ratings by credit rating agency Standard & Poor’s will likely make them even more risky for investors, depending on how corporate issuers react.

After about $10 billion of issuance so far this year, the corporate hybrids avalanche could be coming to a stop. And some corporate hybrids investors could be left high and dry if the issuers of their hybrid notes choose not to exercise the call options attached to them.

The potential for a hybrids hiatus emerged last week when credit ratings agency Standard & Poor’s announced it is reviewing its criteria for assigning equity credit to hybrid notes issued by corporates.

The market for deeply subordinated hybrid securities has been red hot over the last 12 months, as companies have sought the advantage of the “equity credit” granted by the rating agencies and investors have been attracted to the high yields paid by companies to sell the hybrid notes.

However, the rush of hybrid note issuance may be about to come to an end, and a number of the hybrid notes issued over the last 12 months may be called much earlier than investors had anticipated.

S&P’s global review will focus on the criteria for assigning “high” equity content to corporate hybrid capital instruments. This is particularly relevant for Australia and for AGL Energy, Origin Energy, Santos and Tabcorp, who all received 100% equity credit for their recent hybrid issues.

Having 100% equity credit means the hybrid instrument is treated as equity and not debt for the purposes of the rating agency’s calculation of debt service ratios. In other words, the issuer may be able to maintain a higher credit rating than would be allowed if the hybrid instrument was treated as debt.

There was some speculation after the announcement was made that the equity credit granted to these issues would be grandfathered. But the announcement made by S&P makes it clear that any change in the criteria that results from the review will be applied to existing hybrid issues, and any change from “high” equity content to “intermediate” or “minimal” equity content could impact the issuer’s senior credit rating.

The area of hybrid criteria that appears to be in question is the assumption that corporates will not damage their reputations if early call options attached to the hybrid notes are not exercised. This seems a heroic assumption given that these hybrid issues were sold to investors on the basis that call options would be exercised.

The corporate hybrid notes sold over the last year typically have very long terms to maturity, ranging from 25 years to 60 years, but they have call options that allow the notes to be redeemed after just five or six years. Investors were assured by their advisors or brokers that these call options will be exercised, because the equity credit granted by S&P would fall away at that point.  

Thus S&P was granting equity credit to the hybrids because it expected the call option would not be exercised, but investors were buying the hybrids because they expected the call option would be exercised. Someone was either being naive or being misled, and it wasn’t necessarily S&P.

In any event, S&P now appears set to bring this farce to an end.

S&P is expected to bring its criteria for assigning equity content to corporate hybrid capital into line with its criteria for banks. S&P does not grant “high” equity content to hybrid notes with call options issued by banks because the reputational risk to a bank of not exercising the call option is recognised.

If S&P makes this decision, it will turn the cheap “equity” raised by AGL Energy, Origin Energy, Santos and Tabcorp into expensive debt with the metaphorical stroke of a pen.

The CFOs and corporate treasurers of these companies will then have a decision to make. The hybrid notes can be called early, under the capital event trigger included in the terms and conditions of the issues, or, if the notes have also received equity credit from Fitch Ratings and/or Moody’s Investors Service, the notes can be left in place.

The issuers can console themselves with the thought that two out three ain’t bad.

But investors beware. If the notes are left in place without the benefit of high equity credit from S&P, there is even less incentive for the call option to be exercised. The hybrid notes could remain outstanding until their 25 year or 60 year maturity date is reached.

As for future corporate hybrid note issuance, it can be expected that obtaining “high” equity content from S&P will only be achieved if there is no early call option attached to the hybrid notes. This will be much harder to sell to investors.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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