A change to the way hybrids are evaluated by the Standard & Poor’s rating agency has caused a huge amount of angst to hybrid issuers and created uncertainty in a market worth tens of billions of dollars. The sudden nature of the change appears to have caught issuers and investors off-guard. In the past four weeks alone, BHP has issued around $8.8 billion of hybrids in multiple currencies.
The change centres on whether hybrids are treated as debt or equity for capital purposes. For the past few years investment banks have taken advantage of the ratings agency rules that allowed companies to structure securities that pay tax deductible distributions (unlike dividends) yet count partially as equity for capital purposes. This effectively lowers the cost of capital for the company but makes hybrids complex instruments. They have been described as having bond-like returns but equity-like risk.
Billions of dollars have been raised by companies on the assumption that the money will be counted 50% as debt and 50% as equity. S&P’s change means that the hybrids will now be counted 100% debt, and so balance sheet gearing will increase as the amount of equity capital held will drop. S&P said last week that “we now regard these specific hybrids as 100 per cent debt when calculating credit ratios”.
Jonathan Weinberger, head of capital markets engineering at Société Générale said, “S&P didn’t telegraph this: a lot of issuers were surprised by this, investors were surprised by this.”
S&P appear to be zeroing in on the call option in hybrids which gives an issuer the flexibility to redeem the hybrids on an earlier date than the official maturity date under certain circumstances. YieldReport understands that the previous treatment created a situation whereby once a company announced they would redeem a hybrid, ratings agencies viewed the securities as 100% debt. This then triggered the ratings agencies to register an increase in gearing levels as notional liabilities rise and notional equity fall, unless the issuer had firm plans to replace the hybrid with additional equity.
S&P said in a report “We expect hybrids to be permanent, loss-absorbing parts of the capital structure – the prospect that the issuer could call the hybrid instrument if they had lost the equity treatment because of a rating downgrade – that was inconsistent with our view that they should be permanent.”
The problem was illustrated recently by Origin Energy that had hybrids due to mature in December 2016. Had Origin Energy announced they would redeem the hybrids without having made alternate arrangements to raise equity, Origin’s debt may have been downgraded with other flow-on effects. In the end, Origin announced that they would be raising additional equity capital, cutting annual dividends and slashing spending as well as redeeming the hybrids on the December 2016 call date, thus satisfying the ratings agencies.
The new changes are believed to be limited to S&P with the Moody’s rating agency remaining with its previous stance. The changes may mean a number of companies with hybrids on issue may need to redeem them and/or rearrange their balance sheets in order to satisfy the new criteria.
At a minimum there will now be confusion on what the new approach means to issuers of hybrids, and whether all the rating agencies will follow S&P’s lead. Perhaps there will be ratings agency ‘shopping’ whereby an issuer may seek a rating from the agency which will give them a more favourable outcome or a lower cost of capital. Hybrid holders should read the product disclosure statements carefully to ascertain what rights the issuers have to redeem in the circumstances where a material ratings change has been made and what rights holders have in these circumstances.