August 18, 2017 / 11:23 AM / 4 months ago

Banks pitching high equity content hybrids

* Banks get feedback for rare hybrid bonds

* Investors open to issuance as hunt for yield continues

* Product revival dependant on clearing various hurdles

By Laura Benitez

LONDON, Aug 18 (IFR) - Banks are gauging investor interest for corporate hybrid bonds with high equity content, a product feasible for the first time in years as a strong backdrop allows issuers to push market boundaries.

Hybrids have been a popular choice with corporate borrowers in recent years as a way of bolstering balance sheets, protecting credit ratings or funding M&A transactions.

Deals with intermediate equity content have formed the bulk of recent European issuance, whereas high equity content bonds have not been printed since 2011.

“We’ve been pitched this a few times from different banks; it hasn’t been the same bank each time,” one investor said.

“It would obviously be dependent on the name and very much the price - it would need to be very yieldy,” he said, adding that his company would be open to buying such an instrument.

Another investor said banks have been keen to meet and discuss the idea, although timing has not been detailed.

While the first investor said it was unclear whether specific issuers were being lined up, some bankers and investors feel the meetings hint at a potential near-term trade.

A third account said discussions around the instrument have been raised “for a while now” in recent hybrid conferences.

The product could appeal to investors forced to looked to higher returns in a bid to escape the yield compression caused by central bank purchases elsewhere in the sector.

“We are having conversations with issuers about high equity hybrids now. There’s a lot of interest, but some don’t want to be the first to go ahead. But the market is so good, if you can’t take a punt now then when can you?” one banker said.

Strong markets have seen hybrids perform well. The differential between corporates’ senior and subordinated debt is now at around 175-230bp, compared to 300bp in August 2016, bankers say.

ROAD BLOCKS

Before taking the plunge, issuers will have to assess uncertainties around shifting rating agency approaches, which have on previous occasions caught the market off guard.

“There’s such a large hybrid universe now that any erratic methodology changes would dramatically move the market, and investors understandably don’t like that risk,” the banker said.

Unlike banks, which adhere to guidelines set by regulators, corporates are at the mercy of rating agencies as the de facto arbitrators of the features hybrids need to include.

“Every other issuer that has done the 100% equity hybrid has since lost the equity credit, and this hasn’t been done since Dong in 2011 so if anyone was going to do this then of course it would be new,” a second banker said.

Dong Energy lost the 100% equity credit it received for a 7.75% deal when S&P altered its methodology in 2013. Santos and Origin were similarly affected by the change.

In a further blow, S&P removed the equity content of 29 deals in October 2015 - a decision made to reinforce the importance of keeping hybrids as a permanent part of companies’ capital structures.

WATCH THE SMALL PRINT

Rating agency concerns are not the only hurdle. A high equity content deal is riskier than an intermediate one.

Issuers are obliged to suspend coupon payments on such deals if they are downgraded within three notches from the initial rating.

“Investors have to get their head around that increased risk and what price premium they need to be paid,” the first banker said.

S&P does not allow step-ups for high equity content deals as they give issuers an incentive to redeem. Step-ups mean coupons increase if a deal is not called, giving investors a layer of comfort.

“The other risk is around that price element. It’s an illiquid market so there’s not a lot to comp these hybrids on,” the first banker said.

Even supply of intermediate equity content paper has dried up of late having peaked at nearly €30bn in 2015.

More volatile markets and the rating agency changes stifled issuance last year, causing issuance to nosedive to €7.8bn.

While activity has picked up in 2017 with €7bn-equivalent printed so far, it is still a far cry from the market’s heyday.

POTENTIAL CANDIDATES

Any investment-grade issuer considering structuring a hybrid with 100% equity content would have to be rated by S&P or Fitch, both of which - unlike Moody’s - can assign such high credit.

Moody’s on the other hand only gives 100% equity credit to investment-grade corporates’ mandatory convertible hybrids meeting its criteria.

An S&P rated deal would have to include a minimum 10-year non-call period, another banker said, while any issuer considering this is likely to be at best BBB+.

S&P does not allow issuers rated A- or higher to have high equity credit since a mandatory coupon deferral - on a downgrade - must not occur while the issuer is still investment grade.

S&P’s rationale is that an investment-grade entity might be under pressure for reputational reasons to redeem or call an instrument to avoid deferring coupons.

“We would then assess the instrument as not being sufficiently permanent if the trigger were set at a level whereby the entity could still be considered investment grade,” S&P said.

Any company considering issuing high equity hybrids is expected be a non-acquisitive, or somewhat stable rated, innovative company, which doesn’t have too many outstanding hybrids already, the banker said. (Reporting By Laura Benitez, editing by Helene Durand and Julian Baker)

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