Orica's Loaded Dog

The new Orica hybrids are a disaster for investors. Issued under new accounting and ratings agency guidelines, they are perpetual instruments that impose high levels of equity risk on investors, for an insufficient yield (of 135 basis points above the 180-day bank bill swap rate) without any equity upside to compensate investors for taking that risk.

Tagged as the Orica “Step Up Preference Shares” (or “SPS), they are an example of the big bad world of hybrids under new rules which have applied since the advent of international accounting standards in Australia in 2004 (for banks, it gets worse, with the Australian Prudential Regulation Authority stifling their use of hybrids as well).

Far from the glory days of hybrid securities in the early 1990s and the early 2000s, where investors were offered capital protection in hybrids via an embedded conversion mechanism (which allowed them to call for stock in sufficient numbers to return the original value of their original investment), the Orica SPS fails for the following reasons:

1. The SPS are perpetual securities, which rank behind secured creditors and preference shareholders in Orica, but ahead of ordinary shareholders.

2. They are a stapled security, with investors being offered a preference share in Orica plus the benefit of an unsecured note issued by Orica (New Zealand), the latter being the source of the cash flow which services the coupon payable on the SPS.

3. The return on the SPS is payable at the discretion of Orica and yet the SPS is a perpetual security with no maturity date. As such it fails to satisfy both of the key criteria for a fixed interest security: that the investor is paid a sum certain for the time that they are deprived of the use of their money, with that money being returned to them at some specified or ascertainable future time.

4. The SPS has been awarded a credit rating of BBB– by Standard & Poor’s, and this only-just investment grade rating is even lower than the primary credit rating of BBB for Orica’s senior debt. (The ratings is only one notch above the lowest investment grade level of BBB–. Anything below that level can be classified as junk).

5. The return payable on the SPS is a margin of just 135 basis points above the bank bill swap rate, that margin being fixed by an institutional bookbuild conducted last week.

6. To placate nervous investors, the SPS has several structural features that are supposed to make investors believe that the instrument will behave more like a fixed-interest security than it appears at first glance; although on close inspection none of these features are in reality sufficient to overcome the structural risk of this type of security.

7. The key feature of the SPS is that the yield of the bank bill swap rate plus a margin is specified as stepping up by an additional 225 basis points a year at the end of year five, unless Orica has repurchased, converted or “re-marketed” the SPS.

8. Under the innovative “re-marketing” feature, Orica can avoid the cost and delay of bringing a replacement security to market (the proceeds of which would be used to replace the SPS if Orica was repurchasing it), by offering new terms for the SPS to investors (this provision requires agreement by no fewer than 25% of SPS holders to become binding on the remainder, with the rider that investors that don’t agree to the new terms must be bought out by Orica at par).

9. Like many recent hybrids, the SPS contain a “dividend stopper”, which prevents Orica from paying dividends on its ordinary shares if it misses payment on the SPS.

10. Additionally, if the SPS dividend is not paid for 12 months, the SPS holders will experience an “Assignment Event” which means that they will no longer receive payments on the NZ note, and instead will have the right to receive payment from the Orica preference share (but this is only a discretionary obligation of Orica).

Stepping back from all of this, what are investors to make of the Orica SPS? First, the layers of equity risk that are embedded in the SPS are there by design, not by accident. Accounting standards (stupidly) now prevent investors having the right to convert hybrids into ordinary shares; if an instrument conveys this right, it will be classified as a liability and not equity on the issuer’s balance sheet.

Second, ratings agencies have for some time queried the traditional resemblance of hybrids to fixed interest securities, and have not given much equity credit to such hybrids. Orica, like most other hybrid issuers, is concerned to use a hybrid issue to improve their credit rating, and thus are now embedding more layers of equity risk into hybrids.

Hybrid investors need to be aware that when they buy instruments like the Orica SPS, what they are getting contains huge slabs of equity risk, but without the upside that ordinary shareholders receive as compensation for taking that risk. These types of hybrids have no place in the fixed interest component of the portfolio, and unless their yields are significantly higher than that to be paid on the Orica SPS, they should have no place in the equity component either. Unfortunately, for these new style hybrids, it is really now a case of “buyer beware”.

The Orica Hybrids issue is set to close on March 18.

Tony Rumble is chief executive of the Savings Factory, an independent financial services training and consultancy practice.