Rating hybrids closer to senior debt adds more risk
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Rating hybrids closer to senior debt adds more risk

Moody's headquarters in Lower Manhattan in New York is seen on Thursday, April 5, 2018.  (A© Richard B. Levine)

Market should reject the widespread use of a higher rated hybrid

Moody’s has made the unusual decision this month to rate Centrica’s new hybrid capital bond issue just one notch below its senior debt, rather than the usual two. This is a development that will make the hybrid market more risky, not less.

Last week, British Gas owner Centrica returned to the bond market after almost a decade away to sell a £405m 6.5% 31 year non-call six year hybrid.

It was a solidly executed deal that came with a novel feature. Moody’s rated it Baa3, one notch below Centrica’s senior debt. S&P applied the usual two notch penalty for subordination and branded the deal BB+.

The essential difference from a standard hybrid is that Centrica's, although subordinated, is not deeply subordinated. There is room for it to be senior to more junior subordinated obligations, including Centrica's existing £450m hybrid.

Yet Moody's still gave the new deal 50% equity credit.

Theoretically, a one notch downgrade should have tangible benefits for a hybrid borrower. In principle, if investors agree with Moody's, they should price it more tightly than a normal hybrid.

Bankers at the leads differed in opinion about the pricing benefit of the structure. Some said there was none, others that it had come 12.5bp tighter than it would have otherwise.

Existing hybrid investors get the mucky end of the stick, as they are bumped further down the capital stack.

For Centrica, this is hypothetical. It only had one old hybrid, which it was buying back in a tender offer alongside the new deal. Assuming all the old bond is recovered, its investors will never experience being subordinated.

Hybrids evolve

Moody’s made the changes in its methodology to reflect the evolution of the hybrid market. It now requires maturities of at least 30 years on 50% equity credit hybrids, rather than the previous minimum of 60 years.

It also permits a hybrid borrower to time-limit its right to defer coupon payments. In Centrica's case it can only defer for five years, after which it must pay the arrears of interest.

And, like Centrica, an issuer can make a hybrid senior to other junior obligations.

All this while the issuer still gets the crucial 50% equity credit that makes hybrid issuance worthwhile.

Despite that same equity treatment, Moody's argues these changes in tenor, coupon deferrability and subordination can make the hybrid less risky, justifying a higher credit rating.

In fact, the subordination level appears to be the decisive factor, since British Telecom recently issued one that had time-limited deferral and a 30.5 year maturity but was pari passu with existing hybrids, and Moody's rated it two notches below senior.

These changes inject a different type of risk into the hybrid market.

There is already a widespread belief among investors that hybrids are just a good way of buying your favourite investment grade companies but with extra spread.

While this is clearly incorrect — as was seen when Aroundtown shook its hybrid investors at the beginning of 2023 by not calling a hybrid at its first call date —it is still a pervasive belief in the market.

Adding in another layer of subordination, with a higher rating, reinforces this belief. It makes it easier for an investor to incorrectly convince itself that a hybrid is not all that risky.

The minimum maturity change from 60 years to 30 does little to improve the risk profile of a hybrid.

Even when German property company Aroundtown missed its call date, there was not one person in the market who believed it was going to let the deal run to perpetuity.

So what difference will a 30 or 60 year final maturity make to how investors treat a bond they fully expect to be called much earlier?

The enforced coupon payments do make a real difference to the risk profile of a hybrid bond — everyone likes being paid back, even if after a delay — but this is not a feature hybrid bonds should offer.

As was seen in 2022 when interest rates rose and conditions quickly became more difficult for borrowers, the deferrability of coupons and option not to call gave Aroundtown some financial flexibility, even though it ended up paying the coupons.

Investors were not happy, mostly because they had seen hybrids as just senior risk plus a spread, but that was their own fault for not reading the small print. Aroundtown was just playing by the rules.

Moody’s clouding the difference between hybrids and senior debt is a regressive step. The new rating criteria do not properly show investors the inherent risks of a hybrid. At the same time, they weaken one of the main ways in which hybrids are safety valves for companies: letting them defer coupons indefinitely.

Yet the notes still get 50% equity treatment — a high estimation of their resemblance to equity, for what is essentially a bond.

Luckily, Centrica's semi-subordinated structure is not expected to be widely used, partly because of the predictable uproar from investors if a company with substantial hybrids outstanding tries to subordinate already deeply subordinated noteholders by another level.

The market will decide on whether Moody’s idea is good or not. It is looking promising that it will make the right choice.

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