Hybrids retain their appeal despite downgrade wobble

Fri Aug 10, 2012 8:38am EDT

* Value of hybrids stretches beyond ratings protection

* Socio-political factors make RWE's downgrade an exception

* Relative cost of hybrid remains lower than raising equity

* Germany's Linde is possible candidate for hybrid issuance

By Josie Cox

LONDON, Aug 10 (IFR) - Issuing hybrids might not guarantee struggling corporates' credit ratings, but they can play a vital role in generating capital and funding M&A, bankers say.

RWE's downgrade last month, just weeks after the utility completed a USD2bn hybrid bond programme, initially appeared to expose a major flaw in the instrument - especially as the securities cost the company a lofty 7% in coupon payments.

But rather than slamming hybrids as an expensive piece of debt, bankers rushed to the instrument's defence by pointing out they can be a more cost-effective way of raising equity than rights issues.

"RWE obviously failed to achieve one of its goals of the programme -- namely to protect its rating -- but it did achieve its goal of raising funds at the cheapest possible level considering its needs," one syndicate banker said.

RWE's hybrid programme, implemented in August 2011, proved a vital lifeline for the company left reeling after the nuclear Fukushima disaster in March 2011.

A decision by Germany to exit nuclear power put huge pressure on the major players in the utilities sector, including RWE, forcing them to announce asset disposal plans in order to finance the transition to alternate power generation.

In a move to shore up capital, RWE announced a rights issue at the end of 2011, but that fell EUR400m short of the planned EUR2.5bn target - leaving hybrids to plug the gap.

The new shares sold at EUR26 and based on this, as well as the EUR2 dividend that the company pays, this equates to a dividend yield of 7.6% -- substantially higher than the coupon on the hybrid. Furthermore, bond coupons payments are tax-deductible, unlike equity dividends.

When Standard & Poor's and Fitch trimmed RWE's rating by one notch to BBB+ and A- respectively in July, both said that they expected nuclear provisions to continue to weigh on the group's balance sheet.

Kapil Damani, senior capital structurer at BNP Paribas, points out that the efficacy of the instrument relies in part upon a stable business risk profile.

"Hybrids are sometimes touted as a solution to everything and while they are a very appropriate and suitable instrument in many cases, it's important to bear in mind the strains and socio-political pressures RWE is facing."

TAX FILLIP

Hybrid bonds -- which are a blend of debt and equity -- rank subordinated to senior bonds and therefore pay significantly higher coupons to compensate investors for that risk.

Corporate hybrids, unlike their bank counterparts, also have an edge because coupons are both deferrable and cumulative - giving treasurers greater flexibility.

In addition, while a capital hike can significantly burden the stock price and dishearten equity investors, the non-dilutive nature of hybrids means that they can strengthen return on equity and earnings per share metrics for a company.

"It would be wrong to write off hybrids as a means of protecting ratings, just because of the recent downgrades on RWE, which we thought was rather unfortunate," AJ Davidson, head of hybrid capital and balance sheet solutions for EMEA and Asia Pacific at RBS says.

"From a cost perspective, hybrids are still a very sensible option."

In fact, the relative stability of credit markets at a time when equity market volatility remains elevated, should harness the instrument's value, bankers say.

While the VIX -- the implied volatility index on the S&P 500 -- is still trading above pre-Lehman levels, cash continues to pour into corporate credit which is considered a haven. And hybrids, although riskier, offer the most attractive yields in that asset class.

One fund manager, who holds RWE's USD500m 60.5-year NC5.5-year hybrid due in 2072, said that the rating cut had not changed his opinion of the credit or made him reconsider his exposure.

"RWE remains a robust credit and I see the ratings change as insignificant," he said, adding that he also still holds hybrid bonds in BG Energy

M&A TOOLKIT

The use of hybrids in M&A funding has also widened their appeal.

One name that is tipped to access the hybrid bond market is German industrial gas firm Linde, bankers have said.

The company, which in June said that it had agreed to pay USD4.6bn for Lincare Holdings - a Florida provider of oxygen and respiratory therapy services to patients in the home - is no stranger to the hybrid market.

"It's still apparent that an increasing number of corporates are embracing hybrids as a non-dilutive capital-raising instrument," Damani said.

"In the case of acquisitions, hybrids can be a very good tool to plug equity gaps."

Linde has three hybrids outstanding, collectively amounting to around EUR1.5bn. Following its takeover of the UK's BOC for EUR12bn in 2006, Linde then launched a EUR1bn hybrid deal.

In addition to this, the company faces redemptions of around EUR400m next year, which need to be refinanced too.

Other potential candidates for the instrument include Vattenfall, which sold a very well-received hybrid transaction in 2005, and Austrian credits such as OMV, Voestalpine and Wienerberger, which have also been in the market in the past. (Reporting by Josie Cox, IFR Markets; Editing by Natalie Harrison)

Comments (0)
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.