Why corporate hybrids are not all they’re dressed up to be
Securities designed to look like equity for one audience and debt for another are not new. Banks and insurance companies have issued substantial volumes since the late 1990s. And even before the bank tier one and lower tier two markets grew up, corporate hybrids had been knocking around since the early 1990s in the US in the form of preference shares. They have periodically appeared in Asia and a funky market of various exotic hybrid structures has been growing in Australia since 2000.
Why the sudden excitement then? Partly, it’s lack of institutional memory. Bankers move between jobs and firms, and old trades are forgotten. Partly it’s marketing. There are European corporate treasurers and CFOs who like to feel they’re at the cutting edge of the new capital markets technology, not dusting off something Australian corporates were doing six years ago and Americans a decade ago. Mainly, though, it’s down to the rating agencies.
They are now giving greater equity credit than in the past to deals that meet certain standards of subordination and capacity for maturity extension and coupon deferability. Structures that might once have been regarded as 25% equity now get 50% equity credit and ones that used to get 50% equity treatment can now claim 75% equity content. Moody’s has established specific baskets: A for zero equity, B for 25% equity treatment, C for 50% and D for 75% equity.
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“These structures have come a long way” Barbara Havlicek, Moody’s |
Barbara Havlicek, chair of the new instruments committee at Moody’s, says: “These structures have come a long way. There are a lot of factors that drive the way we think about their equity content. And we came to the view that in the past we had been too conservative. So when we announced our refinements in 2005 and gave more equity benefit to hybrids, corporates started to view them more as low-cost equity than high-cost debt.” In the year since Moody’s announcement there have been €9 billion-worth of deals in Europe and even higher volumes in the US.
The rating agencies are intimately involved in every single transaction – not quite in designing them but in passing comment on the implications for equity treatment of each tweak and nuance of structure.
The rating agencies’ input is crucial and it doesn’t come for free. “The rating agencies have different charging mechanisms with a variable component depending, among other things, on frequency of issue, the size of the deal and also depending on the complexity and the amount of time they spend on it,” says Joachim Jäckle, vice-president, corporate finance, at Henkel, which issued one of the largest deals to date in November 2005, a €1.3 billion 99 non-call 10 with a 100 basis point coupon step-up, designed to fund its pension liabilities. Moody’s gave the deal 75% equity credit and improved the German chemicals company’s ratings outlook from negative to stable, citing the deal. “Rating agencies are important players in the capital markets and can help make them more efficient. What I expect from them is clear-cut methodology and transparency, and paying for that service is probably fair,” says Jäckle, “though I sometimes wonder if only the issuer should pay.”
Equity content
Ratings agencies have a commercial interest at stake. They don’t get paid to rate equity but they do get paid to rate hybrids and they want to see the market grow. For that to happen, the agencies have to adjudicate on endless questions of when structures give so much assurance of payment to investors that these reduce the equity content.
There are an awful lot of questions. Under what circumstances can an issuer skip a coupon? Is the decision to skip a coupon entirely at the issuer’s own choice? Can it skip a coupon if it is still paying dividends to equity holders? Or is it mandatory to skip the coupon if the company breaches a certain financial ratio? If so, what particular ratio and at what calibration? If coupons are skipped on payment date, do they have to be paid later, when the company’s finances have improved? Or, once missed, are they lost to investors for ever? (In market parlance, are they cumulative, or non-cumulative.) Can coupons be paid in some other form than cash, for example with more securities?
The ratings agencies like structures with mandatory non-cumulative deferral, meaning that coupons, a little like dividends, are paid only when the company can fully afford them. Investors, of course, want their coupons to be paid always. They want deferred coupons to be cumulative and they want the decision to defer a coupon to be at the issuer’s discretion. Their hope is that any corporate that prizes debt capital market access, that regularly or occasionally rolls over senior debt, will make every effort to stay current on its hybrid coupons, even amid financial distress, so as to keep the bond-investing community on side. Skipping a hybrid coupon won’t tip an issuer into default but it could land it with the biggest investor relations headache it has ever known.
For that reason, investors might be well advised to favour hybrid issuers that have been regular visitors to the debt capital markets and are, to some degree, dependent on access to it.
The result, to date, of all this pushing and pulling has been a wonderful variety of structures. The basic choice might seem to be between optional cumulative and mandatory non-cumulative structures but there have also been optional non-cumulative and mandatory cumulative. The devil really is in the detail.
And that’s just coupons. What about repayment of principal? Equity doesn’t have to be paid back: debt does. How do structurers produce hybrids that both don’t and do? Most European institutional deals have been perpetual non-call 10, with a coupon step-up of 100bp at year 10. This allows agencies to regard them as having the capacity to be permanent capital, while offering investors the comfort that issuers are incentivized to call.
But what if markets make this uneconomic to do? Remember that the call, which supposedly equates to a defined maturity for investors, is an interest-rate option – and in part a credit spread option – of some value resting in the hands of the issuer. Regular debt issuers will face the same moral pressure from investors to call as they will to keep paying coupons. But at some point they will act in an economically rational manner. If the choice is between letting an existing deal remain outstanding and paying the stepped-up coupon versus calling it and refinancing at a much higher rate, will corporates call or extend?
