Rating agencies give unrated perps an edge

Fri Feb 1, 2013 9:16am EST

* Asian investors show preference for calls rather than ratings

* Rated companies forced to push redemption further

* IFRS treatment more lenient than S&P, Moody's

By Neha D'Silva

Feb 1 (IFR) - Recently issued subordinated hybrid bonds from Asian companies had one of the worst weeks ever, with some securities dropping 5% in a few days. Counterintuitively, the bonds that outperformed were those of unrated issuers.

The reason, said market participants, is that a difference between how accountants and rating agencies treat perpetual subordinated debt is giving unrated issuers an edge in Asia, where many investors do not require the backing of Moody's or Standard & Poor's to buy a bond.

The issue centres around the equity treatment of so-called hybrid bonds, debt that does not feature a maturity date and allows the creditor to defer interest payments. Companies have taken advantage of investors' search for yield to issue these higher coupon securities that boost the equity on their balance sheets, hence allowing them to incur more debt without breaching limits set by contracts on prior loans or bonds.

If the hybrid bond meets certain requirements, it can improve the company's credit metrics and avoid downgrades by rating agencies. These standards, however, have become a sticky point for investors and issuers in Asia.

S&P requires that corporate issuers include a legally binding replacement capital covenant, which states that if the company redeems the hybrid bonds within the period when it has equity treatment, it will have to do so with money raised through an instrument with similar equity treatment, namely another hybrid or stocks.

On top of that, both agencies consider that if a hybrid has a date on which the coupon steps-up by 100bp or more, that is an effective maturity date - even if the bond is perpetual. After that day, they will give the security no equity treatment.

And even for the period before a coupon hike, the agencies do not consider the security entirely as equity. Rating agencies emphasize that hybrid instruments need to be similar to equity, which has permanence in the capital structure. So S&P does not give equity credit for the last 20 years before they think the bond will be called, in the case of investment-grade issuers, and for the final 15 years for junk-rated companies.

Hence, if there is a 200bp step-up at the call date in year 10, that bond will not receive any equity treatment at all. To get the equity treatment for five years, investment-grade companies can either include a replacement capital covenant and a single 100bp step-up after 25 years or add a smaller 25bp step-up after the tenth year and incremental hikes in the coupon until year 25.

S&P does not allow any step-up before the tenth year either, although Moody's may still give partial equity treatment to the bonds depending on replacement capital covenants and if the step-up is lower than 100bp in that period.

"We look at hybrids as a form of capital that is going to be available in the event of stress. The way investors assess it is probably completely different and I doubt that you have any investor buying a hybrid instrument thinking that I am going to buy an instrument that will help creditors above me if there is a stress," Standard & Poor's credit analyst Thomas Jacquot said.

The system is supposed to provide some assurance to investors that the equity on the company's balance sheet will behave as such. However, one banker said, it was devised with European and North-American companies in mind. "The staggered structure works for European companies because they are better rated than the Asian ones," said one banker.

For Asian investors, bankers said, a clear indication that a company will redeem its bonds at the first call date is a more important feature than a rating.

As a result, the companies in Asia which would most benefit from issuing hybrids given equity treatment by rating agencies have been suffering badly.

Agile Property Holdings is the perfect example. The Chinese developer in early January issued the first ever dollar-denominated subordinated perpetual by a high-yield company in Asia. The transaction will help it avoid a downgrade while raising additional money for growth.

However, to comply with S&P's requirements, the company will only add 25bp to the spread on the bond after 10.5 years. Investors did not like the fact that until 2023 the company has no strong incentive to call the bond and it has traded as low as 90.00 in the secondary after pricing at 100.00.

Meanwhile, unrated companies can still add in a high coupon step-up in the fifth year and get equity treatment from an accounting standpoint. Under International Financial Reporting Standards rules, a subordinated perpetual note will be considered equity as long as the payment of coupon is at the discretion of the issuer. Hence, if the indenture says that coupons are deferrable, it is equity for the accountants.

The issue came to fore this week, as unrated Philippines oil company Petron issued a subordinated perpetual at 7.5% which has not traded down, even as most perps in the region have plunged.

Bankers say one of the reasons behind Petron's success was its call structure. It has a hefty 250bp step-up from year 5.5, compared to Agile where the first 25bp step-up kicks in after 10.5 years and another 75bp comes after 20.5 years.

One investor, indeed, referred to Petron as having "a solid structure." In Asia, knowing when you get your money, it seems, is more important than ratings.

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