Changing Dynamics In European Bond Market

Fitch Ratings says this month’s revival in hybrid issuance by corporates, traditionally a popular choice for capital raising by financial institutions and insurance groups, reflects the changing dynamics in the European corporate bond market.

“Fitch believes that hybrid bond issuance is probably being used to refinance bank debt or, at the very least, increasing companies’ already-healthy cash-piles.”

Fitch Ratings

The current “sweet spot” in corporate hybrid issuance highlights its attractiveness to yield-seeking investors, given the dearth of investment alternatives. Also, corporates themselves, already attracted by low interest rates, seems to like the pricing arbitrage between senior unsecured and subordinated hybrids.

Adding to the structural shift in European corporate funding from bank loans to bonds, the rating agency believes that hybrid bond issuance is probably being used to refinance bank debt or, at the very least, increasing companies’ already-healthy cash-piles.

“Fitch also believes that there are examples of existing UK utility holding company debt, from banks, which could be replaced by hybrid issuance if existing bond market appetite for hybrids continues,” the firm writes in a press release.

Low Leverage

Hybrids are not a large percentage of a corporate’s capital.

Compared with financial institutions and insurance groups, leverage is obviously much lower for non-financial corporates. Furthermore, corporate hybrids are often not a significant proportion of total debt thus generally insufficient in themselves to affect the corporate’s Issuer Default Rating (IDR), based on the rating agency equity credit calculations.

For those corporate hybrids rated by Fitch, the instruments are typically rated two to three notches below unsubordinated instruments of the issuer at issuance, and on the basis they continue to pay coupons in a timely manner.

To date, in Fitch’s rated European universe, only Pfleiderer AG (‘B-‘/Negative) has activated its bond’s mechanism of deferring coupon payments, which resulted in a downgrade of the instrument rating to denote very low rates of recovery.

Trendsetters In Utility

This month’s revival in issuance has centered upon utility companies: Scottish & Southern Energy plc (SSE) (‘A’/Negative) and Suez Environment (not rated) who have issued hybrids and, according to market speculation,  RWE AG (‘A+’ / Stable) and Cheung Kong Infrastructure Holdings Ltd (CKI) (‘A-‘ / Stable) are planning hybrid insurances.

Fitch notes that these entities are clustered around the ‘A’ and high-‘BBB’ territory.

In the history of recent bond market access, utilities have been able to enter the market despite past disruption, thus it is of no surprise to Fitch that the utility groups have led the charge in issuance of a nominally more complex credit instrument.

For UK utilities, and in the CKI example noted above – it having recently acquired the UK’s EDF Energy distribution companies and financing acquisition debt – hybrids can replace existing 2006 and 2007-arranged bank funding of holding company utility debt.

The Next Big Scoop?

Fitch believes the scope for further similar transactions is quite broad, and spans BAA Limited, the secured covenanted water transactions and gas distribution companies.

During 2006/07, utility groups had holding company debt provided by banks at around LIBOR + 250bp.

Fitch has been concerned that these banks appear to have not demonstrated much appetite to refinance this type of subordinated debt, conceivably at likely pricing above +400bp.

“Therefore, Fitch believes equity owners may look to replace this five-year equity-like/debt-like funding with more of their either own equity or hybrids.”

As an example, given that SSE’s all-in cost for its sterling and euro hybrid tranches was around 5.6% and Suez’s euro-denominated euro hybrid was at 4.8%, hybrids may be an economically attractive alternative for corporates to manage pending refinancing risk.

Here’s an example of a hybrid security, issued by a telecom operator:

For additional information, here’s a copy of Fitch’s research report – Rating Hybrid Securities.



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