A bad month for hybrid investors

Last week Bank of Queensland (BOQ) dispelled the notion that banks' reputations would outweigh their economic interests when it came to redeeming hybrids (see 'Banks caught bluffing'). On 2 November, Standard & Poors (S&P) announced they were reviewing their equity classification of corporate hybrids issued by the likes of Origin, Tabcorp and AGL. It's been a bad month for hybrid investors.

The BOQ incident highlighted just how silly (and risky) these hybrid instruments can be. The BOQ PEPs share price shot up to $98 and then plummeted to $87, in the space of 48 hours, as investors took turns to read invisible tea leaves in an attempt to put a value on them.

As an aside, this raises an interesting point. If an issuer knows in advance they may not redeem a hybrid is this 'price sensitive information' that should be disclosed to the market?

If the BOQ shenanigans weren't enough to do a hybrid investor's head in, S&P have decided they too might change the unwritten rules after the fact. Showing the depth of insight that enabled them to put AAA labels on pools of garbage pre-GFC, S&P have finally woken up to the fact that granting corporate hybrids '100% equity credit' up until the date they can be called early creates an economic compulsion on the issuer to exercise their option to redeem.

Geniuses! The mail boy at JP Morgan (who put together the Woolies II Notes) probably worked out the 'game' on the spot but S&P are just cottoning on 12 months later. It never ceases to amaze me that, despite all the evidence saying we shouldn't, we still place the utmost importance on credit ratings.

Fortunately for S&P they didn't rate the hybrids. So they don't have to worry about any losses that might be suffered by investors. In any event, by giving them 100% equity credit their 'defacto rating' from the investor's perspective was that they were a rather poor credit risk.

Which brings us to an important point. S&P's priorities are to the lenders and issuers, they are providing debt ratings after all. Management of the issuers are focused on returns to shareholders. Neither of them represent the interests of hybrid investors.

Now that S&P have decided to change the rules, a lengthy submission and negotiation process will follow. The interests of the various issuers will be well represented but hybrid investors are unlikely to have a seat at the table.

I have seen some suggestions that corporate hybrids might have been made less risky by S&P's announcements, on the basis the issuers will redeem them once the new rules come in to force. But having spent millions getting these cheap equity deals away, issuers aren't just going to lie down and cop a rule change on the chin. If I had to put my money on the loser out of this process, I would always put it on the guy whose interests aren't represented. So the hybrid investors get my bet.

It seems too simple for the issuers to provide S&P with an undertaking that they won't redeem the hybrids without replacing them with equivalent capital or better. In return, S&P could grant them 100% equity credit in perpetuity. Remember the issuers have an 'option' to redeem the notes, and they don't have to exercise it.

Hybrid investors, left holding notes with 60 year maturities, would cop significant losses and be rightly upset. But the issuers can blame S&P, and S&P can say they had nothing to do with the investor side of things. The brokers who told punters 'of course they'll redeem early' will end up looking foolish, but they'll get over it quickly. By that time, they'll be selling something else.