Hybrids hangover brings on a headache

If something sounds too good to be true, it probably is.

This is a phrase that is commonly used in relation to investment opportunities. And, it is usually the unsuspecting retail investors that get caught out.

I spent a lot of time in 2012 ringing warning bells (to the extent that is possible to ring bells when writing articles like this one) about hybrid notes and the risks the notes posed to retail, mum and dad, investors. See Hybrids: Why take bond returns for equity risks?, Hiding the hybrids facts, and A hybrids game changer.

I commented that hybrid notes were being sold on promises to investors that the notes would be called after five years or so, while promises were also being made to ratings agency Standard & Poor’s (S&P) that the call option would not be exercised.

I also commented that someone was either being naive or being misled, and it wasn’t necessarily S&P.

As it turns out, S&P quickly came to the view that it was indeed being misled, and not investors. S&P announced in November that it was reviewing its criteria for assigning equity credit to these instruments, flagging the likelihood of retrospective changes being made. S&P realised it needed to focus much more on the intentions of company management when determining the equity credit that should be given to a hybrid note, rather than the provisions, options and discretion built into the documentation.

S&P subsequently brought 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 issued by banks because the reputational risk to a bank of not exercising the call option is recognised. 

The revised criteria was released last week, and S&P promptly stripped four Australian hybrid note issues of the 100% equity credit allowed and did the same to two hybrid note issues in New Zealand. With the exception of the hybrid notes issued by oil and gas group Santos, all hybrid note issues were sold to retail investors and are listed on their respective stock exchanges.

The four Australian companies affected are AGL Energy, Origin Energy, Santos and Tabcorp. The New Zealand companies are Contact Energy and Genesis Energy. Santos has come out of this worst of all.

Santos’ ‘BBB ’ long term rating is now being reviewed for downgrade by S&P,and the €1 billion of debt on which it is paying 8.25% per annum is just that – debt. To be more precise, it is very expensive debt. S&P is granting no equity credit at all, with the full value of the notes being counted as debt on Santos’ balance sheet.

Santos expressed its displeasure with S&P in a release to the ASX, stating it was disappointed by the retrospectivity and inconsistency of the decision, which it said came after detailed consultation undertaken in 2010 – prior to it issuing the hybrid notes.

Tabcorp had the outlook on its ‘BBB’ rating changed to negative, which simply means there is a one-third chance that the rating could be lowered in a couple of years or so.

Tabcorp and the other companies affected will continue to receive 50% equity credit for their hybrid notes, but with a coupon of 400 basis points over the 90-day bank bill rate, it is questionable whether the notes will continue to provide value to the company. Tabcorp advised the ASX that it does not intend to immediately redeem the notes under the capital event trigger that is contained in all of these issues, but it reserves its right to do so.

The New Zealand companies, Contact Energy and Genesis Energy, are both considering whether to exercise their right of early redemption, while both AGL Energy and Origin Energy have said they will not redeem their hybrid notes issues because of S&P’s criteria change. In fact, AGL Energy said in an ASX release that it believes the notes still add value to its balance sheet.  

This is a rare example of companies getting their fingers burnt rather than investors. The opportunity to turn debt into equity was too good to be true.

The lesson learned is what rating agencies giveth, rating agencies can taketh away. This may stop the rush of corporate hybrid note issuance seen last year dead in its tracks.

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.