Issuance of hybrid capital in Europe surged at the start of the year and is likely to remain elevated in the near term. Taron Wade discusses how such instruments are rated and why new issuers are getting involved
European issuance of hybrid corporate capital – a funding instrument that has both debt and equity characteristics – shot to €8.2bn in the first two months of this year, already topping the €5.2bn in volume for all of 2012 (according to data from Dealogic and Standard & Poor’s calculations).
Hybrid capital has mainly been the preserve of utilities over the past few years for two key reasons. The first is that utilities, particularly regulated grids, tend to require heavy capital expenditure, and because ratings agencies may treat a portion of the hybrid capital as equity it is a useful means for utilities to protect their credit metrics while executing ambitious strategic objectives.
The second reason is that many utilities have state or local municipality owners and so cannot resort to the equity market for additional capital. Meanwhile, using hybrid capital allows them to diversify their funding sources.
But now issuers from other capital-intensive sectors such as telecoms are starting to take part. This is in response to sector challenges but also comes as a consequence of the relatively attractive interest rates now payable on hybrid instruments, compared with historical levels. Given our gloomy outlook for economic growth in the euro-zone, we believe that levels of hybrid issuance from European corporates will remain elevated in the near term, provided that investor risk appetite stays strong.
Part equity, part debt?
Hybrid capital instruments have been developed with the goal of gaining recognition as being equity-like – that is, being granted ‘equity content’ by Standard & Poor’s and other rating agencies – and, in some cases, being treated as capital by regulators. At the same time, these instruments are generally more cost-effective (for example, by being tax deductible) than common stock, and typically do not affect the earnings-per-share denominator.
In their most common forms, hybrid capital instruments afford equity benefit to issuers, in part, by having ongoing payment requirements that are more flexible than interest payments associated with non-deferrable senior debt, and by being contractually subordinated to such debt. Obviously, these characteristics make the instruments more risky for investors than non-deferrable debt.
In assigning issue ratings to equity hybrids, we seek to reflect the incremental risks associated with the issue in terms of payment timeliness and principal recovery compared with non-deferrable debt. We typically reflect these risks in our issue ratings on equity hybrids by assigning them ratings that are lower than those on non-deferrable debt.
Our corporate criteria for hybrid debt first looks at an issuer’s financial policy and whether we believe it is committed to retaining the hybrid as a piece of permanent loss-bearing capital. We also consider whether, in the event of pressure on its credit quality, the issuer would activate the credit-protective features of hybrid capital by, for example, deferring interest payments.
If we believe that there is such a commitment, then we look at three aspects of the security: the instrument’s degree of permanence or its effective maturity; the instrument’s degree of subordination to other debt; and whether interest payments can be deferred in times of credit stress.
A credit committee may give the hybrid instrument ‘intermediate’ or 50% equity credit if:
• We are comfortable with the issuer’s financial policy commitment to retain the instrument as a piece of permanent loss-bearing capital, and;
• The instrument meets the aforementioned three conditions, and any further relevant conditions as specified in our hybrid criteria.
Hybrids that we assign ‘intermediate’ equity credit are the most common type of instrument we see issued by corporates. We may also assign ‘high’ equity content to some hybrids, although that is much rarer.
Although utilities have dominated hybrid volume in recent years, issuers from other sectors are beginning to take part, particularly telecoms. These companies are taking advantage of high investor interest and attractive terms, while supporting their balance sheets and credit ratios.
For example, Telekom Austria AG issued €600m of hybrids that S&P rated BB+ in January 2013, and Koninklijke KPN NV issued €1.1bn and £400m in hybrid securities that we rated BB in February. Telecom Italia SpA completed its first hybrid in March, raising €750m.
More recently, Hong-Kong based Hutchison Whampoa’s euro-denominated perpetual securities were assigned a BBB rating by S&P in May.
Incumbent telecoms operators are facing difficult operating conditions, which are putting pressure on their ratings. At the same time, they need capital to invest substantially in fourth-generation mobile and fixed broadband networks to remain competitive. For example, we downgraded KPN in February due to its falling operating margins on the back of fierce competition and higher commercial investments. Nevertheless, the company aims to protect its credit metrics, and consequently its investment-grade rating, with its plan to raise €4bn in equity through a fully underwritten €3bn rights issue and the issuance of up to €2bn worth of hybrid bonds.
Hybrid debt in Europe is still dwarfed by overall corporate bond issuance (which totalled close to €270bn last year). Because it is a riskier instrument for investors, windows of issuance are often shut by economic volatility and external shocks. Take the banking crisis, for instance, which wiped out issuance in 2008; or the fears of contagion in the euro-zone following Greece’s debt restructuring in 2011, which resulted in less hybrid issuance that year.
Nevertheless, recent conditions have been favourable, and companies have taken advantage of increased investor appetite, issuing hybrid debt at increasingly lower yields. For example, in early January 2013, French waste company Veolia Environnement issued a euro-denominated hybrid bond with a coupon of 4.45%, which we rated BBB-. This compares with the 6.5% coupon on BG Energy Capital PLC’s euro-denominated hybrid bond in June 2012, which we rated BBB+. The rating distribution of recent hybrid bond issuance reflects investors’ increased appetite for risk, since BBB- and lower-rated bonds have returned in large volumes for the first time since before the banking crisis.
In the currently difficult operating environment, with negative growth in the euro-zone as a whole, we do not expect the popularity of hybrid issuance to abate for some time, as long as the investor search for yield continues.
Taron Wade is an associate director in corporate ratings at Standard & Poor’s