Caltex top-up may not be enough

The subordinated notes issue by oil refiner Caltex may not prevent a ratings downgrade.

PORTFOLIO POINT: The subordinated notes issue by oil refiner Caltex may not prevent a ratings downgrade.

Caltex launched a $300 million subordinated note issue yesterday, after flagging the issue last week when it announced its supply chain restructuring and the closure of its Kurnell refinery.

The proceeds raised from the issue will be used to cover at least some of the costs associated with the restructuring. However, the “equity credit” that Standard & Poor’s is expected to give these notes may not be enough for Caltex to avoid a rating downgrade to BBB, from BBB .

S&P placed the BBB rating assigned to Caltex on credit watch, with negative implications, when the restructure was announced. S&P also provided a possible escape clause for Caltex when it said the restructuring would likely be positive for Caltex’s business profile. So, Caltex may avoid a rating downgrade. In any event, apart from needing to raise cash, the equity credit that S&P should give to the subordinated notes provides the motivation for the structuring of the issue and the means of analysing its merits.

It is also useful to consider structural features of other subordinated and hybrid issues that have been undertaken this year by companies other than financial institutions.

Tabcorp was the first to come to market this year, with a deeply subordinated hybrid issue. Tabcorp was followed by AGL Energy and then came Seek, with the most aggressively structured issue of all.

Seek was unable to convince investors that a perpetual note, with deferrable, non-cumulative coupons was a good investment. This was despite the fact that the coupon would have a credit margin of 500 to 550 basis points over the 90-day bank bill rate, and if the notes were not called after five years the spread on the coupon would increase by a further 200 bps.

Leaving aside a whole range of other problems with the structure of the Seek notes, the biggest problem was that the coupon may never be paid at all. This must be the best possible perpetual debt of all, but, strangely, enough investors wouldn’t take it up.

Investors did not really rush to Tabcorp or AGL to buy their hybrid notes either. Neither company upsized their issues and they sold only $200 million of notes, in the case of Tabcorp, and $650 million for AGL. Both issues have firm maturity dates, of 25 years and 27 years, respectively, and the notes are callable after five years and seven years, respectively.

In both cases, there is a 25 basis point coupon step-up if the notes are not called, but the coupons can only be paid if mandatory coupon deferral triggers have not been activated. Deferred coupons are non-cumulative.

Both issues received 100% “equity credit”, which means the notes are treated as equity and not debt for the purpose of assessing the credit-worthiness of the issuer, and, thus, determining the long-term credit rating assigned.

Finally, both issuers can buy the notes on-market after the call date has passed. This is very nice for the issuers because the notes will be a lot cheaper then.

So, how do the Caltex subordinated notes compare? The Caltex notes have a 25-year term to maturity, are callable after five years and have a coupon step-up of 25 basis points if the notes are not called. Sound familiar, so far?

There are some differences though. While the coupons are deferrable at the sole discretion of Caltex, there are no mandatory coupon suspension triggers and the coupons are cumulative and compounding.

That said, the coupons can be deferred for up to five years. Dividend payments and equity buybacks must also be suspended while coupons are not being paid, but employee-shareholders can still receive dividends – presumably, this includes management too.

Table 1: Caltex Notes Issue Details

The differences in the terms and conditions applying to the coupons are sufficient to ensure that the notes will receive an "intermediate equity credit", which means only half the value of the debt will be treated as equity by the rating agency.

Caltex will also have the ability to buy the notes on-market after the passing of the call date. Caltex is quite explicit in its information memorandum, stating that it regards the notes as being a key part of its capital structure and therefore is not committed to redeeming the notes on the call date.

Moreover, while Caltex will not receive intermediate equity credit from the rating agency after the call date, it will receive "minimal equity credit".

This means the rating agency will treat the full face value of the notes as debt, but, because there will still be 20 years to run before maturity and coupons are deferrable, these features will be considered when determining the long-term credit rating that should be applied.

The question for investors is whether a coupon based on a 450 to 470 basis point margin over the 90-day bank bill rate is sufficient to compensate for the credit risk of Caltex itself, a 25-year term to maturity and the risk of coupon deferral for up to five years

The bookbuild for the issue will take place this time next week and the coupon margin will be announced the following day, when the issue will open. The issue will close to shareholders and the public on August 28, and deferred settlement trading will begin on the Australian Securities Exchange on 6 September.

The Caltex issue brings the total senior, subordinated and hybrid notes issues offered to retail investors this year to a record $8 billion.


Philip Bayley writes for Banking Day newsletter, in which this article first appeared.