Corporate hybrid cries out for reform — but the task looks impossible

Try explaining corporate hybrid capital to someone who hasn’t heard of it. Like an American. Can you keep a straight face?

The product is a Heath Robinson contraption built out of broomsticks and sticking plaster to solve for three different rating agency criteria sets, IFRS and sometimes national accounting systems, and umpteen national tax rulebooks.

Last week Standard & Poor’s broke one of the rubber bands holding part of the edifice together, by deciding it was no longer happy to grant equity credit to 29 bonds from 14 issuers.

The reason is that these bonds would be callable if they ever lost equity credit from Moody’s as a result of the issuer’s downgrade to speculative grade. That, in S&P’s view, makes the instruments not properly permanent. The issuer could call them at a moment of distress, just when it needed them.

It would take all day to list all the baffling, inconsistent and illogical aspects of this market. The thing is that no one in the market, except journalists, likes to talk about them. The market, just as it is, suits everyone.

Issuers get the balance sheet benefit of issuing equity, while in fact issuing a much cheaper instrument. Not only are hybrid coupons much lower than an issuer’s return on equity — but they are tax-deductible like bond interest. It’s a free lunch.

This benefit appears in the eyes and minds of the rating agencies, the accountancy profession and even bank lenders (shouldn’t they know better?) At first, the stockmarket scoffed, seeing hybrids as expensive debt. But recently, it too has been getting with the programme and buying into hybrids’ benign effect on balance sheets.

Investment banks of course like the product because it’s an instrument they can market, with lots of bells and whistles. And investors like it, because they can buy investment grade corporate risk but get 200bp or 300bp of extra spread.

To most market participants, this is a win-win, good for everyone. If something can be all things to all people, why not? Who’s the victim (apart, perhaps, from the tax collector)?

Theoretically, the potential loser is the senior lender or debt investor. The purpose of hybrids is to support senior credit quality. But are hybrids really as good as common equity at protecting senior lenders from loss?

Things that can go wrong with hybrids include the rating agencies or some other body such as regulators or accountants taking away their equity credit.

In one sense, that is only someone’s opinion — if it changed, it would not weaken the balance sheet. But it is these opinions investors have bought into in the first place. To the extent that hybrids had any purpose in the first place, they should have kept the senior debt spread tighter. Losing the equity credit, that implies, should lead to a widening of the senior spread.

This means there is a credit spread cliff risk with hybrids that is absent with equity.

This is why Moody’s opinion that speculative grade issuers’ hybrids do not deserve equity credit is so baffling. What were the hybrids for in the first place, if not to protect senior investors if the issuer ever got into credit problems? How is that end served by stripping the equity credit upon downgrade to junk?

No wonder issuers wanted a call option to get rid of the deals if that happened.

Standard & Poor’s is being just as muddle-headed, though, in allowing hybrids that issuers can call if they lose equity credit because of a rating methodology change. If it is bad for the equity credit to suddenly disappear, then it must be bad in all cases, whether or not it is the rating agency’s fault. This view of S&P’s smacks of being nice to issuers, rather than rigorous credit analysis.

Another problem with hybrids is that, however much rating agencies wish them to be permanent, like equity, they aren’t.

S&P analysts will need to look away now, but everyone else acknowledges that investors want hybrids to be callable on predictable dates. They know they are highly likely to be called on the expected dates, because S&P will remove the equity credit then.

So what happens if an issuer is in credit trouble just when one of its hybrids is coming up to a call date? If it calls the hybrid and issues senior debt, that is a sign of confidence and market access, but it will lose the equity credit and weaken its balance sheet. And S&P will get frightfully cross.

If the issuer declines to call, it sends a signal to the market that it is in distress. The likely effect would be a sudden spread widening — not what senior investors want.

And if it calls the hybrid and issues a new one, it would have to pay a much higher yield, weakening its cashflow.

Which would be the best course of action for the company? It would be a tough decision.

Another oddity is that the rating agencies are not content to let companies make these decisions according to what seems best to them, but want to control their behaviour years in advance, when the situation is only an imaginary scenario.

A further argument that the equity credit in hybrids is not quite as good as the real thing is that the rating agencies themselves cap the amount of hybrids that a company can issue, relative to its actual equity. The level is arbitrary.

Investors, too, need to examine their priorities. Fixed income fund managers’ raison d’être is to own assets that yield interest. Why, then, are they so obsessed with hybrids being called on time? Who cares if a deal is extended? The investor gets the yield for longer — it saves it the hassle of reinvesting. Defaults, of course, are bad, but call options are not what protect investors from default.

It would be easy for a journalist, with no skin in the game, to say the whole caboodle makes no sense — scrap it and replace it with something more intellectually coherent.

Say, companies had the choice of issuing subordinated debt — like high yield issuers do — which would be debt for tax and accounting purposes and support senior ratings, but not have equity credit.

Or they could issue preference shares, which were like equity but with some kind of more bond-like coupon or maturity profile. Look at the US capital market, where companies seem to thrive without the benefit of hybrid capital, but there is a pref share market.

The formats would be agreed by all, and not require complicated arrangements of call options and coupon step-ups. Then this could genuinely become a commoditised asset class.

The snag is, as one leading issuer pointed out this week, this is not a new market, but an established one, with billions of euros of paper now outstanding. Major reform of it would be an immense headache for the issuers, and for investors.

 Letting things stay as they are, and working out a patch for each new problem that comes along, remains the least worst option for all market participants.

Unfortunately, as the financial crisis has shown us, the reckoning will come one day. Financial products that are too clever by half, that enable people to call something fish to one constituency and flesh to another, come to grief in the end.

How it will play out is not clear yet. It may take years. It might be a company, or group of companies, going bust and people discovering that its hybrids did not offer as much protection as expected.

At that point, the regulators or politicians will step in and set rules for the market, which are unlikely to be as friendly as today’s informal patchwork of guidelines. That is what happened with bank capital.

Until then, hybrid issuers and structurers should not be too hard on S&P. It’s trying its best to play your game.