Rating agencies and hybrid securities have not always had a great relationship. As the three largest international firms attempt to get to grips with the role of high yield corporate perpetuals, it is not unusual for one of them to announce changes in its methodology without warning and without grandfathering the changes.
Standard & Poor’s upset the market last year by altering the rules and the year before it was Fitch under fire. The natural successor to the hot seat is Moody’s, which made changes at the end of July to its debt and equity treatment for hybrid instruments of speculative grade non-financial companies.
These have been largely ignored in Asia since then. For much of this summer the market has been shut even to senior debt from blue chip names, so the minutiae of high yield perpetual bond structures were not at the forefront of bankers’ minds.
But now that a combination of weak data and party politics in the US has taken the prospect of QE tapering firmly off the cards for 2013, and the debt ceiling debacle has been temporarily resolved stateside, Asia’s bond market looks well set for a revival, with some bankers forecasting a volume and variety of deals not seen since the start of the year.
This means that in theory, high yield perps should be back. The signs are there. At the time of going to press, Aluminium Corporation of China (Chalco) is marketing a senior non-call five bond. If successful, this would be the first US dollar-denominated perpetual deal since May.
But the structure is highly conservative and while the bond itself is not rated, the issuer is an investment grade (‘BBB‘) name. In addition, it will have a 500bp step-up, meaning the issuer will have almost no choice but to call it at the call date.
Despite the fact the private bank bid for Asian debt has returned, investors are still not totally comfortable with buying back into perps after many existing deals seriously underperformed over the summer, according to bankers.
This trepidation is not at all soothed by the recent changes announced by Moody’s. The idea is that from now on, high yield perps will either be classified as legal form bonds or legal form equities with no grey area between the two. Either the agency is comfortable with the instrument and it gets 100% equity treatement, or it is not, and therefore the perp is relegated to the 100% debt pile.
The problem is that the changes will be retroactively applied, and the ratings agency is in the process of removing the equity credit from a series of outstanding non-investment grade hybrids.
This is tricky both for issuers and investors. Companies are naturally uncomfortable issuing a high yield instrument and paying up to 200bp or 300bp more for it if they many not get the desired outcome.
High yield perps tend to have some protection built in so that if the issuer loses equity, accounting or tax treatment it is able to call the bond – some of these triggers are as low as 101. This makes surprise rule changes easier for companies to stomach, but equally if an investor knows that an issuer may call the bond at short notice, this will make them much less likely to want to buy.
So prospective high yield hybrid issuers in Asia are worried. If the Chalco deal goes well and is followed by a few investment grade trades, lower quality companies who want to look at hybrids will need to think very carefully about how to structure the instruments in order to ensure they are still tax deductable but also that they remain investor friendly.
In the meantime, bankers are trying to work out how such a structure would work. Many are having discussions with Moody’s, but the rating agency has reportedly been relatively closed when it comes to allowing bankers to propose hypothetical structures – saying it will rate any instrument only once it launches.
Moody’s is right to change its methodology if it thinks it is necessary but it should consider working more closely with banks to give feedback on potential structures. Admittedly there is a certain element of second guessing, and rating agencies cannot give bankers too much to work with, or else they will quickly find the limits of new rules are being tested before they have even been finalised.
However, surprise rule changes, particularly ones that are not grandfathered, are not helpful for the market. If issuers and investors are uncertain about how to structure a deal or the potential implications of new rules, it makes trades much more challenging until familiarity resumes. And if the the goalposts are constantly being moved around this can have a long-term detrimental impact on the market.
Hybrid instrments are important for the capital structures of many companies, especially those with a focus on growth, and they should not be discouraged by arduous or fickle rating agency requirements.
Agencies themselves are always keen to stress that their ratings are not a moral judegment, or advice to buy or sell, but simply an attempt to describe an instrument. But by showing themselves willing to remove equity credit that issuers have paid a hefty premium to achieve, these firms are coming dangerously close to making a moral call.