Its change of heart on October 27 stunned issuers and investors as it meant that €20 billion worth of hybrid bonds issued by several well-established issuers such as Dong Energy, Vattenfall, Alliander, Centrica, SSE and others went instantly from achieving 50% equity credit to 0%.
The surprise move stemmed from S&P’s concerns over issuer behaviour following any downgrade from investment grade to sub-investment grade. Under Moody’s rating criteria, equity credit would be lost in such an event, and the issuer can call the hybrid.
However, S&P believes that a hybrid has a primary function in such a situation to absorb losses to protect other more senior obligations, and therefore no longer agrees that such bonds can be called.
The point of difference is small and technical, and has been swiftly dealt with by the affected issuers who committed not to call the bonds if they drop to sub-investment grade.
On November 10, both Vattenfall and Dong Energy said they had enacted deeds of undertaking under which they irrevocably waived their right to call the bonds. Alliander followed suit on November 12 and more issuers are expected to do the same.
“The deed of undertaking is such a simple solution which can be enacted without bondholder approval and which should not upset anyone that we expect it to be widely adopted,” says Andrew Moulder, analyst at CreditSights.
While the episode does not appear to have caused any lasting damage to the sector, it has reawakened investor nervousness over the rating agencies’ ability to disrupt issuer and investor confidence that the hybrid product has matured.
“This absolutely caught people by surprise,” says one hybrid investor. “People felt that it was now very much a standardized market, almost a commodity. This episode has served as a reminder that it isn’t. It is very disappointing.”
Methodology changes at the rating agencies have dogged the development of the corporate hybrid market, but stability since 2013 had lulled the market into a false sense of security. Moody’s decision to remove equity credit from all hybrid bonds issued by a company rated Ba1 or lower in August 2013 caused turbulence and was a reminder that rating methodologies can be subject to rapid change.
Although S&P’s move in October was a change in opinion rather than methodology, the impact was equally frustrating for some.
“This is a lesson for issuers and structurers that if you move away from standard terms the rating agencies may be unpredictable,” says another investor. “This was a simple, small point on an option that hasn’t happened and hasn’t been in the money. If you are a corporate treasurer that has just lost millions of euros worth of equity credit I can imagine this is very annoying.”
|Trevor Pritchard, S&P|
“It is not our objective to add to concerns in the market,” he explains. “We want to be predictable. That is why we publish our criteria. Different committees had come to different opinions on the view on permanence of some hybrids. That prompted a re-examination of the views on permanence and that led us to reconsider earlier opinions. We stood back and asked whether these hybrid documents were really providing the loss-absorbing cushion that is needed to justify intermediate equity content.”
He adds: “Even if the issuer commits to replacement in the event of a call following a rating downgrade – what is the point of the call option then?”
While the agency may feel that its approach to the sector is predictable, many disagree.
“We continue to be amazed by S&P and its vacillation over hybrid bonds,” Moulder at CreditSights said when the announcement was made.
“Moody’s is not guilt-free, with its removal of equity credit for hybrids when the senior rating drops out of investment grade, but it was S&P that changed its methodology and cut equity credit on Dong and Santos to zero from 100% in 2013, it was S&P that suddenly realized Alliander’s replacement capital covenant dropped away when its rating rose, despite having raised its rating to the required threshold some two years earlier and it was S&P that was singularly unhelpful in its comments around hybrid replacement when RWE was trying to decide what to do with its 2010 hybrid (which it called and replaced in 2015).”
Investors were frustrated because the opinion change was completely unexpected.
“We wouldn’t have classified the language difference punished by this as weaker language. It was a surprise,” says Gordon Shannon, portfolio manager at TwentyFour Asset Management in London. “We make a note of all the key differences between the different hybrid issues but I wouldn’t have highlighted this one. This is a reminder of how important it is to know the individual covenants of these bonds. There always were some differences. The one that S&P picked on was not the one we expected them to.”
The issuers that S&P hit with its move are for the most part regular hybrid users. As the asset class grows, however, such episodes of disruption will prove increasingly damaging.
Issuance of hybrids by non-financial companies hit $46 billion in 2014.
French electricity utility EdF transformed the market with its €4 billion trade in January 2013 – at the time, the largest ever – and issues have been getting steadily larger since then. Volkswagen issued a $4.2 billion hybrid in March 2014, followed by Bayer’s $4.4 billion trade in June and Orange which inked a $3.9 billion deal in September of that year.
In February this year, Total’s €5 billion corporate hybrid was a sign of the extent to which investor appetite for the asset class has grown. The deal attracted an order book of nearly €20 billion.
As more and more investors move down the capital structure in search of yield, the appetite for hybrid risk will only grow. And as corporate hybrid issuance broadens out to include more cyclical businesses the need for the rules to be clearly understood by all sides becomes imperative. The prices of the affected hybrids converged on 101 after S&P’s move at the expectation that they would have to be called.
Given that S&P’s change of opinion has been mitigated by the deeds of undertaking by issuers, it raises the question whether such issues could not be dealt with in a less disruptive manner.
“The rating agency should have given guidance to affected issuers as to what change in language was needed to get equity treatment,” reckons Shannon. “Issuers could then pay a premium to change the language in the bond with no market disruption.”
Pritchard dismisses such an approach, but concedes that the rating agencies need to be very aware how they transmit their thoughts to the market.
“It is always important to consider the process by which we communicate our opinions to the market,” he says. “We would not flag up our thinking to issuers before making a public announcement because of selective disclosure issues and the risk of information leaking into the market.”
In the meantime, however, investors are left with a sense of lingering uncertainty about an asset class that many felt had put such disruption behind it.
“If you were short or long the wrong bonds this must have been a nightmare,” says Shannon. “Bonds with higher cash prices have been harder hit. As a buyer of corporate hybrids you must either buy it below par or, if you buy it above par, make sure you do your due diligence.”
And many are fed up with bearing the brunt of rating agency changes of heart. “Whose problem is it if the rating agency looks back and says actually this is not what we wanted?” asks another investor. “S&P signed off on these instruments.”