In the following article we will look at hybrid notes and take a deeper look at the treatment of such securities.
What makes a hybrid?
Firstly, what is hybrid security? It is a type of a note designed to take elements of both debt and equity, creating a hybrid exposure which lands somewhere on a spectrum between the two. Hybrid securities are often structured in a way that they are either convertible into common equity, are ranked junior to debt securities and have coupons that have priority over dividends to common shares. Financial institutions use a specific type of hybrid, known as Additional Tier 1 (AT1) most commonly structured as Contingent Convertible bonds (CoCos). These are considered highly equity like and are structured to protect a bank’s balance sheet in times of high market uncertainty, working as an additional capital buffer with CoCos getting converted to common equity given certain events are triggered.
Rise of European undated hybrid securities
The negative interest rate environment which has prevailed for much of the 2010’s and early 2020’s, European issuers in capital-intensive industries, such as telecommunications, utilities, and real estate, have turned to undated hybrid securities to diversify and add equity layers of protection to their capital structure. At the same time fixed income investors have been looking for opportunities that offered yields above senior unsecured bonds from investment grade rated issuers. The security of choice has been an undated hybrid security that is structured similarly to AT1 but generally without conversion triggers to common equity.
The particular type of hybrid notes in question are structured with a set of comparable terms across the different securities as set out below.
- Undated – i.e. no maturity dates.
- Ranking junior to senior debt, but senior to common equity.
- Coupon resets every 5 years to the prevailing 5-year swap rates at the time of reset plus a margin. The margin is set at the issuance with increases (“step-up”) at pre-determined dates, generally 10 years and 25 years following the issuance.
- Voluntary call options for issuers at each interest payment date, or more frequent, starting at the first coupon reset date (i.e. after 5 years).
- Issuer option to defer (but not cancel) coupon payments, subject to limitations on distributions or capital measures related to securities that rank pari-passu or junior to the hybrid securities (known as “pushers” or “stoppers”), i.e. no dividend payments on common shares.
- Coupon deferrals are cumulative, but not compounding.
- No covenants or default rights.
Equity characteristic of the undated hybrids is recognized under IFRS and these securities are considered as 100% equity instruments. They provide additional security cushion for senior debt investors, whose covenants are positively impacted by these hybrids. As a result, pricing of these hybrids is between that of equity and debt.
For issuers there is a clear benefit to this kind of hybrid securities. From a cost of capital perspective, an issuer could optimize its capital structure using senior debt and common equity or could add a share of hybrid capital as an additional equity layer at a cost in between equity and debt. These securities became attractive in capital intensive industries in the low interest rate environment of the mid-to-late 2010’s. The cost of such hybrids was often closer to the cost of senior debt than equity. Issuers used their first call option to call the hybrids and replace them with a similar new issuance at the same time, making the securities debt-like in practice but at a superior yield. However, similar to the AT1 security for banks, the undated hybrids provide companies with options to navigate markets when liquidity is scarce, allowing corporates to prioritize the servicing of senior debt and thereby reducing the risk of default compared to a capital structure which was comprised of only debt and equity.
Fixed income investors also benefited from the higher interest where rates are close to zero for investment grade senior debt. This allowed such investors to increase returns at what was considered to be a small increase in risk.
Impact of rating agencies
S&P and Moody’s look for characteristics of these instruments which usually consider these securities as as 50% debt and 50% equity, or even 100% equity. Moody’s generally does not change its view of equity content after the issuance of a security. S&P views these securities as 100% debt following a non-call by issuers. This has a negative impact on issuers credit rating, although still considered 100% equity for bond’s covenants. This contributes to the issuers to call the notes on the first call date and replace them with a new issuance.
S&P would consider a hybrid where the coupon is deferred to be in default until such coupon is being paid again. It has negative implications for the issuer’s credit rating although it has positive impact on the covenant headroom of the issuer as the unpaid dividends and coupons increase the liquidity and improve the net debt ratios. S&P expects issuers to remain committed to hybrid securities in their capital structure, and therefore does generally not allow issuers to call such securities at the first call date without replacing these with another similar equity like instrument.
Examples of corporates that have issued undated hybrid
In recent years undated hybrid securities have been issued by different sectors,in telecommunications, such as Orange, Telia, Telefonica and KPN, utilities, such as EDF, Orsted and Engie, banking such as Credit Suisse, as well as real estate, such as Vonovia, Unibail-Rodamco-Westfield (URW), Aroundtown, Grand City Properties (GCP), Heimstaden and SBB. These companies operate in capital intensive sectors. For such companies undated hybrids can be a valuable additional to the capital structure in order to shield them from market uncertainties during the lifetime of their assets. When looking at the real estate sector, we see that the three largest listed companies in the sector, Vonovia, URW and Aroundtown, have issued hybrids. Vonovia replaced its last hybrid with a mixed issuance of debt and equity in 2020. Both URW and Aroundtown continue to hold hybrids in their capital structure.
Current market environment and higher coupon rate after non-call of undated hybrid
Since the middle of 2022 interest rates are rising while capital and liquidity have become scarce. It is uncertain how long capital market liquidity will remain constraint. This has a significant impacts on the market for undated hybrid securities, which dried up since then. Several issuers have decided not to call their undated hybrids.
Looking at examples in the real estate sector, we can see that URW chose to launch a exchange offer whereby it offered its hybrid holders an increase in margin and annual coupon as well as cash payment not exceeding 10% of its overall hybrid balance, in-line with S&P’s rating restrictions. This exchange offer has a negative impact on URWs financial position due to the cash outlay. Aroundtown with its subsidiary GCP, have decided to not use their option to call the hybrids, and as a result the hybrids reset to higher coupons in-line with the terms of these securities. Aroundtown has a large share of its capital structure comprising of hybrids and as a result a transaction such as the one from URW is likely not economical. Moreover, it would make sense for Aroundtown to treat its hybrid investors equally, which is likely driver for their non-call decision.
When the issuers announced their decisions not to call their hybrids, the market reaction was fair as it came with sound economic rational. The decision whether to exercise such a call option should be based on a forward-looking basis, factoring in the expected liquidity position in the mid to long term. Recently, as the cost of equity and debt remains high, there is a general acceptance that such securities will not be called in the first call date as most of the securities that are now coming to their first call date were issued at the time of ultra-low rate and at the time the demand for such products was high. As a result, the re-set rate, which maintains the low spread set at the time of issuance, is significantly lower than the re-issuance rate of a similar security.
It is therefore to be expected that issuers use their possible options in a market where there is low liquidity and high uncertainty. These hybrid securities increasingly show their equity like attributes which provide companies with the ability to control its cash flow in extreme times. Control over the cash flow and cash retention at times of a liquidity shortage is beneficial for debt holders, as they are prioritized due to their seniority. Furthermore, when the risk of covenant breach is increasing due to falling valuations, hybrid note holders also benefit, as it enables the issuer to focus on improving its balance sheet and liquidity, allowing for more time for recovery. This is true by not calling back the hybrids and also by using the issuers option to defer the coupon payment. Historically, companies that did not anticipate a liquidity shortage and did not act ahead of time or have embedded deferral options within their balance sheet, diminish value for all stakeholders as they are more likely to suffer from insufficient liquidity to serve their liabilities where market illiquidity remains for a prolonged period. An example for this situation is Credit Suisse, which has completely written down its hybrid notes in March 2023.
CS could have better protected its hybrid holders if it would anticipate the liquidity stress ahead of time and would stop hybrid cash outflows. In that case, CS hybrid holders would have not received their coupon payments, but the access liquidity created from this saving would have strengthen the liquidity increase its headroom to covenants and perhaps prevent from the hybrids eventually being written off.
Issuers that did not call their hybrids have, in most cases, the option to call the back the securities at any later interest payment date. It can be expected that issuers that decide to defer the coupon payment on the hybrids will suffer reputational damage in the short term, but as there is a very strong economic rational and mid-long term positive impact to all investors (bonds, hybrid and equity), it can be expected that in the long-term the impact will be positive to all stakeholders under these circumstances.
Treatment of undated hybrids if markets remain restrictive
As capital markets and the liquidity situation remain highly uncertain, it is likely and to be expected that more issuers will decide not to call their hybrid at their first call date. The longer the markets remain restrictive, it might result in deferral of coupon payments, which is another liquidity retention option embedded within the securities. It is an important feature of the notes to support companies cash flows at time of liquidity shortage.
The cash retention benefits all stakeholders as it protects the issuer in the long-term by limiting the cash outflows only to those that are necessary and obligatory. This would allow an issuer to maintain headroom to its covenants and use its cash to serve interest payments and reduce debt, in-line with balance sheet seniority and thereby reducing the potential risk of a default in a prolonged stress scenario. If coupons are deferred, they likely will be paid eventually as the issuer is able to successfully navigate the difficult environment. In times of uncertainty, deferring coupon payments and retention of cash will eventually be at the benefit of all stakeholders – the debt holders, which will benefit from healthy performing bonds, and hybrid and equity investors which will benefit as the company will successfully navigate without covenant breach, defaults or liquidity shortage.
However, the market perception of deferring the coupon payment of the hybrids might be different. Not paying the coupon can be interpreted as a signal that an issuer is either in liquidity distress or anticipates that it may soon be in distress situation. For rated hybrids the rating will drop to a ‘D’ or default rating which is expected to cause market volatility on the hybrids, bonds and equity. Per the general terms of such hybrids, in this coupon payment deferral event, the company is not able to distribute dividends to common shareholders until deferred coupons have been paid.
However, it is important that issuers focus their efforts on increasing the company cash flow and not try to satisfy short-term market reactions to its decision whether or not to defer the coupon payments.
Following this logic, in May 2023 the holding company of SBB announced its decision to defer coupons. S&P is anticipating SBB itself will also defer hybrid coupon payments in the next twelve months, as per a rating action announced in November 2023. Although SBB’s hybrid notes and share performance has been significantly hampered as a result of this decision, we expect that the increased cash flow will support SBB in the long term and balance the company. Once the company will pass these turbulent times, then investor confidence will resume to the healthier and stronger company.
Another interesting situation is Aroundtown which has a Hybrid volume of close to €5 billion. It announced last year that it considered to defer its coupon payments but eventually paid them during 2023. As the real estate market continues to suffer for a prolonged period, it would be interesting case to see if in 2024 Aroundtown will choose to pay or defer the hybrid coupons. Choosing to defer the coupons will signal a responsible cash flow management with long term view to protect all stakeholders, while paying the coupon will signal that management has a long term positive outlook of the market.
