S&P reversal leaves blue chips unbalanced

In a decision akin to reverse alchemy Standard and Poor’s turned $3.6 billion of equity into debt yesterday, which will force a number of large Australian companies to re-evaluate their balance sheets.

Last November S&P announced that it was reviewing the assumptions and methodologies it had used to determine the equity content of ‘’certain corporate hybrid capital instruments’’. The review was in response to a global flood of issues by corporates of hybrid securities – securities that counted as equity for ratings purposes but carried a cheaper debt-like coupon.

In Australia Santos, Origin, Tabcorp, AGL, Crown, Caltex and APA were among those to issue hybrids, with the first four gaining 100 per cent equity credits for their issues.

Santos was the first of the local issuers to put its hand up yesterday, saying that its $1.23 billion issue would be reclassified as debt and that S&P had placed it on creditwatch with negative implications. It also said it had no need for further equity or debt facilities, with $5.8 billion of cash and undrawn debt facilities.

Origin chimed in this morning, saying that its issues of hybrids, totalling about $1.5 billion, would no longer qualify for 100 per cent equity content and that the change in equity content (it appears the securities may still have some equity component to them for S&P’s purposes) was a ratings event under the terms of the securities and therefore it had the right to redeem them. It is considering whether to exercise the early redemption rights, although it is highly unlikely that it would exercise them if, for instance, they still carry 50 per cent equity credit.

Tabcorp, which issued $250 million of subordinated notes last year, said the equity content of its hybrids had also been reduced and that it had arranged a partial underwriting of its dividend reinvestment plan for its next two dividends. AGL, with $650 million of hybrids in the market, is still trying to assess the implications of S&P’s move. Other hybrid issuers weren’t awarded 100 per cent equity content in the first instance.

The overnight conversion of $3.6 billion of equity, or at least a good portion of it, from equity to debt will have a material impact on the balance sheets of the companies most affected.

The appeal of the hybrids was that they could be treated as equity for ratings purposes but were cheaper than equity because they carried debt-like interest rates and were regarded as debt for taxation purposes, with the costs deductible.

As debt, however, they are expensive in an era of very cheap funding for major corporates, with coupons generally around the 7 per cent to 7.5 per cent range. That’s why there will be serious consideration given to refinancing them with conventional debt or equity.

The hybrids are complex securities which proved very popular with retail investors because of their high yields despite the fact that they were generally subordinated and the issuer generally controlled the redemption option, had the capacity to extend the maturity of the securities for decades and could withhold interest payments if its financial position weakened. Their complexity prompted the Australian Securities and Investment Commission to issue a warning in which it described hybrids as ‘’highly risky’’.

Last year global issues of hybrids, previously not a mainstream product, exploded in response to the global search by investors for yield against the backdrop of very low interest rates. There were, for instance, more hybrid euro issues in the first three months of this year than in any previous 12-month period.

While Santos and Tabcorp are the only companies so far whose ratings have been affected, any issues with high equity content now carry a major question-mark next to them and the issuers will be reviewing their funding strategies.