Hybrid theory

Corporate hybrid bonds, which combine features of debt and equity securities, have proved to be a popular way for credit investors to seek enhanced returns on their favoured borrowers. This is usually in return for additional subordination and extension risks, among other things. At the same time, they can offer companies more favourable treatment in credit ratings, tax and accounting.

A key feature of the asset class is that the credit rating methodologies have been mostly stable for years – in particular regarding the amount of ‘equity content’ granted. This is the component of the instrument that the rating agencies consider to be equity when they calculate leverage metrics. Equity content is important for companies, so they typically demand an option to repurchase the hybrid in the event of one of the agencies changing its approach. This repurchase option is at a fixed price, which may be below the market price. Hence, stable rating methodologies  can make hybrids more appealing, for both companies and investors.

New methodologies

However, there have recently been some changes in rating methodologies that raise questions for investors, and more are at the drawing board.

The first change was Moody’s update in February. This change opened the door to a new breed of instruments that Moody’s rates only one notch below the senior rating, rather than two for the standard structure, while still being granted 50% equity content by the agency. 

These new instruments would be subordinated to senior bonds, but would rank ahead of existing hybrids. Many recent newly issued hybrids haven’t made use of the new structure, indicating that the market is yet to adopt it as standard, but we have now seen several companies make use of it. Some of these companies have deferred the feature and the one-notch benefit to these instruments beyond outstanding call dates to avoid subordinating their legacy hybrids.

More to come?

The second development was S&P’s advance notice in July of a proposed reduction in equity content on hybrids that include ‘sliding step-up’ features. 

While the proposed change affects only a small number of hybrids, if it were to go through companies with those hybrids might incur unexpected costs modifying or replacing them. And investors could also lose out, if hybrids were to be called below market value. Ironically, this second proposed change illustrates the risk to investors of participating in new non-standard structures – such as those prompted by the first change above.

While we consider stable rating methodologies to be a key investment factor for corporate hybrids, we see these particular changes as relatively small-scale and we don’t think that they significantly undermine the overall investment proposition. 

However, we will closely monitor how companies make use of additional leeway from the rating agencies. More generally, we will also be on the lookout for any further changes to rating methodologies that could impact outstanding hybrids or the companies that make extensive use of these instruments.