Dr. P.V. Viswanath
The Rating Game
|From The Economist, Nov. 2, 2013|
The latest fashion in corporate borrowing has a familiar air
As corporate-bond issuance has swelled in recent years, so have its more exotic offshoots. None is more exotic than “hybrid” bonds, of which €23 billion-worth ($32 billion) have been issued in Europe this year, according to Royal Bank of Scotland, more than doubling the size of the market.
Banks have been issuing instruments called hybrid bonds for a while, most recently as part of the effort to strengthen their balance-sheets after the financial crisis. Investors in such issues will be “bailed in” (their debt converted into equity) if the bank gets into trouble. But corporate hybrid bonds are different—indeed they are rather odd creatures. Their main appeal is that they are treated by rating agencies as part-bond, part-equity; most recent issues have been classified as half-and-half.
This classification is important. A company that issues a lot of new debt risks having its credit rating lowered. A lower rating means it will have to pay a higher interest rate on its future debt issues, to reflect the increased risk of default. Issuing a hybrid bond makes a downgrade less likely.
At the same time, issuing a hybrid bond is cheaper for the company than raising the same amount of money in the form of simultaneous bond and equity issues, in part because the interest on bond issues is tax-deductible for issuers, but the dividends on equity are not.
Most hybrid bonds are not convertible, meaning that investors cannot swap them for equity at a certain price. The majority of them are never turned into shares, so a company can issue them without risking diluting the stakes of its existing shareholders. So what makes them equity at all? One reason relates to the interest payments: in certain circumstances, the issuer has the right to stop paying interest, just as a company has the right to stop paying dividends on its shares. The usual proviso is that the hybrid bond’s issuer must keep paying interest on them if it is still paying dividends on its shares. And if a bond issuer misses an interest payment or two, it will usually be expected to make good the shortfall once its finances recover.
This provision makes hybrid bonds more risky than conventional debt; investors naturally demand compensation in the form of a higher yield. A recent hybrid bond issued by Telefónica, a Spanish telecoms group, carried an interest rate of 7.625%.
Hybrid bonds have one other odd feature. In theory, they have very long maturity dates. Some have notional lifetimes of 60 years, whereas others are supposedly irredeemable, meaning that the principal is never repaid and the bond keeps paying interest forever. That is another way in which hybrids are said to resemble equity, which also in theory never expires.
In practice, however, the bonds come with call options that allow the issuer to redeem them after five years. That reduces their cost, explains Marcus Hiseman of Morgan Stanley. The yield curve for debt is usually upward-sloping, meaning that the longer a bond takes to mature, the higher the interest the issuer will have to pay. The call provision allows hybrid bonds to pay a rate that is closer to five-year than 60-year yields, while still masquerading as a close relative of equity.
Complex financial instruments designed to earn a particular label from ratings agencies have an inglorious history: the mind turns to the subprime mortgage-related bonds that caused so much trouble in 2007 and 2008. At the moment, hybrid corporate bonds do not seem as opaque and flimsy as many of the subprime issues proved. But given enough time, the industry has a knack for turning innovations into monsters.