This week ratings agency Standard & Poor’s finalised its review of hybrid equity credit which resulted in retrospective changes to around $3.6 billion in hybrid capital for Australian companies, including large retail issues from Origin and Santos. This is just the latest episode of rating agencies draping themselves in technical failure…which is supposed to be their core competency.
What happened?
Hybrids by their nature are technical beasts. They are supposed to be a mix of equity characteristics and debt characteristics, hence the name hybrid, and are at their heart designed to appease various regulatory requirements, tax requirements and/or the requirements of the rating agencies.
The hybrids affected by the changes were specifically designed to meet S&Ps own criteria for equity enhancement and now, with these changes, S&P has acted retroactively on instruments specifically designed to appease them. Under S&P’s criteria, companies (with the help of their bankers) could design their hybrid in such a way that they would receive 100% equity credit for their issue. But now S&P has changed its mind, taking away the 100% equity credit and placing some companies under rating pressure. What was previously cheap equity, is now expensive debt.
What does 100% equity credit mean?
So what is the argument all about? When reviewing companies, rating agencies calculate credit ratios to help assign the rating. The most commonly known credit ratio is gearing calculated as Debt/(Debt + Equity). When a company’s hybrid is given 100% equity credit, it doesn’t count as debt in making this calculation, so the gearing of the company appears lower when assigning the rating. If the hybrid is given 50% equity credit, half of its value is applied to debt in the calculation; if it is given 0% equity credit, its full value is applied to debt. This is shown in the example below.
[1]By receiving 100% equity credit for the hybrid in the example above, the company is able to effectively reduce its gearing, as calculated by the rating agency, from 50% to 33%. By doing this, the company may maintain, or improve, its credit rating while still achieving its funding needs. The hybrid may also allow the company to avoid offering a dilutive equity raising to the market, to otherwise meet its funding needs.
Santos has a €1,000m hybrid, which has gone from 100% equity to 0% equity – effectively applying an extra €1 billion to the company’s balance sheet over night. Its credit rating is now under pressure. Origin, which has a $900 million hybrid and a €500 million hybrid received 50% equity credit, adding over $700 million to its balance sheet. The ASX-listed Origin hybrid was issued at 400 basis points over the bank bill swap rate. Given its current rating, Origin would raise senior debt at around 200 basis points. This hybrid, which was once cheap equity, is now expensive debt.
Doomed to failure
Perhaps what is most surprising is that any of these issues received 100% equity value in the first place. At the time the Santos hybrid was issued, I noted that S&P was loose in its application of the equity credit allowance, even under its own (old) criteria. The cumulative nature of deferred provisions in the structure was a significant ‘debt-like’ characteristic, which for me should have immediately ruled out any chance of full equity credit. The rush of issues following the Santos precedent probably highlighted to the rating agency that it had gotten it wrong and forced the review.
The result
As a result of this back flip, the rush of hybrid issues seen last year has well and truly dried up. It also highlights the need for investors to fully understand the complex nature of hybrids – most are not particularly debt-like and investors looking for fixed income investments for their SMSF should tread carefully. The losers as a result of S&P’s change in approach will not be limited to the companies and the rating agency.
For the purpose of full disclosure, I note that I have previously worked at a credit rating agency (not Standard & Poor’s).
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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- Paul Rickard: Question of the week – Transferring shares into an SMSF [6]
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