Moody’s is exposing the shaky foundations underpinning the hottest product in European corporate finance.
The ratings agency has decreed that “hybrid†debt is still debt, even if it resembles equity. This may sound like a statement of the obvious. But companies and investors need to digest it.
Hybrid debt ranks below senior debt but above equity in a company’s capital structure. Unlike senior debt, the issuer has freedom to suspend coupon payments and defer repayment of principal. That makes hybrids a bit like equity, whose dividends are variable and which never needs to be repaid. Investors like hybrids’ high yields, and companies prefer them to equity because coupons, unlike dividends, are tax-deductible. Sales are at a record 29 billion euros this year.
Moody’s previously treated 50 percent of hybrid debt as equity when assessing companies’ overall leverage. Earlier this month it said it would treat hybrids as 100 percent debt if a company’s credit rating falls below junk. That means hybrids could act as an accelerant when a company’s creditworthiness is deteriorating.
It’s an unpopular decision - but logical. When a firm is struggling, the risk of its assets eventually having to be liquidated to pay creditors increases. Hybrid debtholders would then have a claim up to the value of their debt plus any deferred coupons. If they were equity investors, that would not apply.
There aren’t many junk-rated hybrids out there. Still, the change has caused pain to issuers and investors. Brickmaker Wienerberger saw its rating fall a notch after Moody’s policy statement pushed its debt up to 6.5 times last year’s earnings before intrerest, taxes, depreciation and amortization, or Ebitda. Telecom Italia’s 7.8 percent hybrid, sold in March, would look like expensive debt if it was junked, giving the company cause to redeem it and refinance. Junk-rated ArcelorMittal’s debt jumped by $3 billion. Its hybrid fell 5 percentage points on concerns the steelmaker may now redeem it below its recent market price.
This comes as a rise in risk-free rates threatens to diminish the attractions of hybrids. It’s another reason for companies to issue either debt or equity, or a mix of each, but not something pretending to be the best of both.
Neil Unmack is a columnist at Reuters Breakingviews. For more independent commentary and analysis, visit breakingviews.com.
