RSS feedsTo get the best aspects of debt and equity, corporates in the US and Europe are piling into so-called hybrid financing, creating an instrument that has more flexibility than senior debt and reduces the cost of capital. The boom in hybrid issuance has been driven by changes in the way the credit rating agencies treat these instruments.
Their flexibility is recognised by Standard & Poor’s and Moody’s and given a certain amount of equity credit. The rules, particularly pertaining to Moody’s, changed about a year ago in such a way that they became clearer and more favourable towards hybrid instruments.
With the fresh approach adopted by Moody’s, corporates are now much more comfortable with the level of credit they obtain with a hybrid instrument. S &P and Fitch have clarified and updated their views to reflect the fact that the market has grown and changed with regard to structures that they felt needed to be addressed.
“An issuer can get more equity credit for an instrument now, according to Moody’s, than in previous years,” says Jennifer Piekut, executive director and global head of Morgan Stanley’s Capital Products Group. “From the equity perspective, there are features built into a hybrid that replicate those you would find in ordinary shares.” There are three equity-like aspects to hybrids:
Long-dated Hybrid instruments are typically structured to be long-dated or even perpetual. An issuer has no obligation to repay, or that obligation is far out in the future.
Subordinated The second factor that makes hybrid capital more akin to equity is the subordination of the instrument. “It is typically subordinated below all debt and senior to common equity,” says Piekut. “But by virtue of this subordination relative to senior debt, hybrid instruments create a cushion.”
Interest deferral The third aspect is the option to defer interest payments. “There are many ways to achieve this, but all hybrids will have some form of deferral risk built in, so an issuer can, in certain circumstances, choose not to pay the hybrid capital dividends,” Piekut explains. “By having some coupon deferral it’s similar to an ordinary share, in that if the company is in trouble it has full flexibility to suspend ordinary share dividends.”
Hybrid instruments also have features that make them more like debt. Piekut points out that these instruments typically pay a fixed coupon and have a fixed liquidation value. “If the company does well you don’t have equity upside and only get back what you put in, which is par value,” she says, drawing the distinction with convertible bonds, the original debt-equity hybrids. “Hybrids are typically non-voting and structured to be tax deductible in whichever country you’re dealing with, which makes them more similar to debt.”
This newest generation of hybrid capital has taken off in the US in the past six months or so and there have been some important changes on the bank regulatory side that create a new opportunity for US banks.
In Europe, where the bank regulatory environment has been stable for the past seven or eight years, it has been the changes on the part of the rating agencies that have driven the market. Whether investor appetite for such higher-yielding products survives a downturn, in which corporate issuers exercise their right to defer interest payments, is yet to be seen.
