Corporate hybrids: Telecom Italia caught in hybrid ratings trap
Moody’s strips equity credit from €750 million deal on downgrade to junk.
When Telecom Italia announced a €3 billion hybrid programme in February, it was with the express purpose of shoring up its credit rating.
The firm issued €750 million non-call five-year hybrid bonds priced to yield 7.875% in March. The deal was one of a wave of hybrid corporate bond deals sold earlier this year that seemed to push the boundaries of what is possible in this risky asset class.
Barclays and JPMorgan were joint structuring advisers and global coordinators on the 60-year deal, with Banca IMI, Barclays, BNP Paribas, JPMorgan and Mediobanca as joint-bookrunners.
However, the Italian phone company’s efforts to remain investment grade proved futile on October 8, when rating agency Moody’s cut its rating to Ba1 from Baa3 – a widely anticipated move.
The agency cited the recent resignation of CEO Franco Bernabe as increasing uncertainty over the company’s ability to strengthen its balance sheet as the cause for the move. Standard & Poor’s is due to complete a review of the firm in late November when a downgrade from BBB- to BB+ is on the cards.
Telecom Italia’s hybrid was one of several from European telecoms operators earlier this year, but was seen as being towards the more challenging end of what could be done in this market. It offered a 175 basis point yield pickup over KPN’s hybrid issued just a week before.
The Dutch telecommunications firm offered double-B rated bonds at 6.125%, which shortly thereafter came under pressure when dividend payments were halted for 2013 and 2014 – giving the firm the option not to pay the coupon on the hybrid. It is now embroiled in a hostile takeover battle with América Móvil’s Carlos Slim.
Moody’s recent decision to change its hybrid methodology has been a blow for the asset class. In August the rating agency announced that a hybrid bonds issued by a company rated Ba1 or below will now be treated as pure debt.
This means Telecom Italia’s outstanding hybrid bonds have now been stripped of their 50% equity credit and will be treated as 100% debt. This is bad news for a firm with €28 billion of bonds outstanding.
The bonds are unlikely, however, to be called. “Moody’s has now removed the equity credit assigned to the €750 million hybrid,” says Suki Mann, head of credit strategy at Société Générale. “Telecom Italia can thus exercise its issuer call at any time following this rating methodology event [issuer call at 101 until the first call date, at par after the first call date, current price €99.375].
“An early redemption of the hybrid should be the lowest priority for Telecom Italia. The hybrid bonds trade below the early redemption price and the group will have large annual refinancing requirements that it will need to focus on now that it may be migrating into high yield.”
He notes, however, that the firm would still get some equity credit for the hybrid bonds with S&P, even if S&P cuts it to junk.
All outstanding Telecom Italia debt could come under pressure from forced selling as the issuer inevitably migrates to high yield.
“Telecom Italia is eliciting much angst, comment and concern,” says Mann. “It’s a large borrower, a national champion and operates in a normally defensive industry, but it is under pressure and could be joining the HY indices before year-end.
“Telecom Italia debt will comprise approximately 5% of the HY iBoxx index and 25% of European HY TMT space [for euro denominated bonds], and it has ongoing funding needs of €3 billion to €5 billion a year.
“The company will go from being a fish in a pond to being a whale in a puddle if it does get downgraded [by S&P].”
Of immediate concern to hybrid bondholders is the risk that coupon payments on the hybrids are deferred. Given Telecom Italia’s funding plans, the risk of this is deemed low.
"Although Telecom Italia could expect to fund in the high-yield market at below the current yield to the 2018 first call on the hybrids, it is unlikely to abandon its plans to issue hybrid debt totalling €3 billion unless it views investment-grade ratings as unachievable in the near to intermediate term," says Mark Chapman, analyst at CreditSights. He warns, however, that coupon deferral is a material risk in the event of a dividend suspension and capital increase. "As unpaid coupons on Telecom Italia’s hybrids are cumulative, but not compounding, we would expect a significant market reaction to suggestions that coupons could be suspended."
It is not only rating agency downgrades that can prove a headache for hybrid bondholders. The upgrade by S&P of Dutch network company Alliander from single-A plus to double-A minus in August this year should have been good news for bondholders, but it might not be for those holding its €500 million hybrid.
Hybrid bonds incorporate replacement capital covenants (RCC), which are legally binding covenants covering the refinancing of these bonds with similar capital after their call date. In Alliander’s case it was deemed that the RCC no longer applied at the higher rating level, which triggers a rating event and removes equity credit from the deal. There is therefore now a risk that management might call the bond at 101.
It might do nothing, but the episode highlights yet again the multiplicity of risks that hybrid instruments encapsulate.