sales of corporate hybrids, a five-year high
Along with a favourable judgement by rating agencies on how hybrids affect an issuers credit rating, sales of European corporate hybrid bonds have surged to a five-year high of 5.2 billion in little more than a month. In September alone, UK power company Scottish & Southern Energy sold £1.2 billion of the securities, followed a few weeks later by German utility RWE, which issued 1.5 billion. In between these, Suez Environnement and Australian oil company Santos completed smaller deals, after Dutch power utility TenneT had got the ball rolling in February.
Most of this paper has been structured in the same way. The securities are perpetual with optional issuer calls at par after five and 10 years and every coupon payment date thereafter. Interest payments are optionally deferrable. Calls after five years are governed by a legally binding replacement capital covenant (RCC), with intention-based replacement language covering all issuer calls. In return the companies get a 50% equity credit from both Standard & Poors and Moodys. This enables companies to raise cash for acquisitions and investment without compromising their existing credit ratings, while the paper is also tax-deductible.
The issuance surge (predicted in Euromoneys January 2010 issue) is a turnaround: there had been no activity in the hybrid market since June 2007. The catalyst came in July when Moodys redefined its treatment of hybrid capital. It had decided to review its classification because of the credit crisis, when some classes of hybrids had failed to absorb losses in the way they were expected to, particularly those issued by banks. The new framework consisted of five baskets: A to E, where equity credit ranged from zero to 100%. The new rules gave favourable treatment for corporate issuers, which surprised the market. A syndicate banker noted at the time: "Everybody thought that Moodys was going to make life very difficult for corporates to achieve basket D equity treatment, but it seems it has made it less difficult than expected."
The low-yield environment has been a sweet spot for credit-rating-conscious borrowers and investors. Six months ago, a hybrid might have priced at a coupon of 8% to 9%, according to Barclays Capital. SSE, for instance, issued at just above 5%. "Over the next few months and heading into next year could be the busiest period for corporate hybrids we have ever had," says Wayne Hiley, head of European corporate syndicate at Barclays Capital in London.
Companies last issued hybrids in a big way in the boom years of 2005 to 2007 when they were used to finance acquisitions. During the crisis, hybrid debt issued by banks was hit hard, with many banks seeing prices on these securities fall to 20% to 40% of their face value. Some investors claim they are flawed, because they are a form of equity without any potential to benefit in the stocks upside. In effect it is debt masquerading as equity, says one investor. To be fair to corporate hybrids, they did perform better than bank-issued hybrids, with prices on average falling to between 75% and 90% of face value. Thats mainly because, with a few exceptions, they continued paying coupons, none were deferred, and consequently they now trade at around par, according to Deutsche Bank.
Some in the market are not convinced the hybrid revival is healthy. While ratings agencies have argued that hybrids are good news for senior bondholders because there is now a small cushion beneath them (hybrid securities count as subordinated debt), there is now more debt to service. Richard Ryan, a fund manager at M&G in London, said last month that it was disappointing to see what looks like another wheeze getting equity risk into bond portfolios coming back so soon after being proved flawed.
Syndicate bankers, however, argue that the marketplace is now much more straightforward. "The good old days of 2005 and 2006 where everyone was structuring in their own way, where each deal brought something a little bit funkier, has disappeared," says Matthias Minor, head of corporate DCM at Royal Bank of Scotland in London. "That should help in the development of a secondary market."