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Tuesday, November 22, 2011

Column: "Attack of the Hybrids!" (for Eureka Report)

I had a column on the new "hybrid products" published by Eureka Report last night...

Attack of the Hybrids!

Big “hybrid” issues have become all the rage amongst retail and, more surprisingly, institutional investors in an environment where there is limited demand for straight equity. But the question is: what’s the difference?

Woolworths has issued $700m worth of its oversubscribed hybrids, which are to be listed on the ASX on November 25. Now Origin Energy is about to complete its own $500m hybrid issue, once again targeted at mums and dads with an ASX listing slated for end December.

The principal marketing message seems to be that these hybrids offer a “premium” return over cash. While this is true, I would argue that it is utterly inappropriate to compare hybrids to cash given the two wildly different risk profiles.

Indeed, it is almost as bad as saying a high dividend yielding stock, such as one of the big banks, is better than cash purely on the basis of a yield comparison. What about the fact that you are putting at risk a big chunk of the capital value of your investment when buying shares?

Any objective analysis finds that investors are getting a raw deal with these hybrids. In short, they are being asked to accept debt returns in exchange for significant equity risks.

The notion that this represents an unfair trade-off is confirmed when comparing them with the notably “non-hybrid” subordinated debt issues offered by other major Australian companies. These investments provide comparable, or better, floating-rate debt returns relative to the hybrids, but with substantially lower risk of loss.

When a smart investor thinks about the word “hybrid”, they normally conceive of an instrument that has debt-like downside protections with equity-style upside.

The Woolworths and Origin Energy hybrids literally turn this logic on its head: they lump investors with debt-like returns in exchange for equity risks. And this is not opinion: it is fact, as we shall see.

Given the favourable characteristics of these offers for the issuers, it is no surprise to see more and more coming to market. If you could get away with raising funding that has a debt cost of capital, but with equity risk-sharing attributes when things go badly, you would do so every day of the week!

Before we dive into the risks, one needs a bit of background.

Irrespective of whether a loan is “senior” or “first ranking”, or “subordinated” or “second ranking”, the normal lending rule is that the borrower must always pay their interest commitments.

The reason you invest in debt is precisely because (1) you get a secure, regular income based on guaranteed repayments by the borrower, and (2) if the borrower does not pay you that income, you usually have rights to force them to do so.

If the loan is secured by an asset, such as a home, you can take possession of it and recover your principal and interest. If the loan is unsecured, like these hybrids, you can normally force the company to take action to repay your interest or, at the limit, push it into liquidation.

Now let’s consider the unusual range of risks investors face when lending to Woolworths and Origin via the hybrids. And, remember, that’s what you are doing: you are providing funding to these companies, and are therefore a creditor to them.

The first thing to note is that both loans have super-long terms. Origin’s hybrids have a 60 year term, while Woolworths have a 25 year term.

As a lender, or investor in debt, your risk increases with the length of the loan term. Why? Because the longer the loan term, the higher the probability the borrower (Woolworths or Origin) will one day default.

Here Phil Bayley, publisher of the Debt Capital Market Review, adds, “there is a not insignificant risk that these [Origin hybrids] will become perpetual--any bond with a term to maturity of more than 50 years is effectively perpetual.”

Sure, they are listed on the ASX, so in theory you can trade in and out whenever you want. But that is during the “good times”. What happens if either company stops paying interest? You can bet liquidity will dry-up quickly, and you may be stuck in the hybrids unless you are prepared to take a big mark-to-market loss.

The second, and perhaps most significant, feature of these two hybrids is that both companies have a free option to not pay you interest. Yes, that’s right—they get to choose whether they service the interest on your debt or not. And not just for a few months. The two hybrids allow Woolworths and Origin to pay you zero interest for up to five years.

These “deferred” interest repayments then roll-up and start earning interest on interest. While this might sound okay, you can bet that if they ever exercise this option you will have a double-whammy: the listed value of the hybrids will fall significantly as the market starts pricing in the risk that the company can never fully meet its obligations under the hybrid.

In the case of Origin, there is another catch. If the company suffers a “ratings downgrade” to below investment grade (ie, BB+ or lower), the company must automatically stop paying you interest until it recovers its investment grade rating.

The only cost imposed on the companies when they cease paying you your interest is that they must also stop paying dividends to shareholders. But this would be the least one would expect in any default event: the hybrids purportedly rank “above” shareholders’ equity, and so normally the company would be forced to use its dividends to repay the interest on these loans.

Yet Origin and Woolworths don't actually have to do that. That is, they can stop paying interest for five years so long as they stop paying dividends, but they don't have to use any of the money saved from the dividends to make good on the hybrids.

The third issue is that neither hybrid has been rated by the rating agencies. A rating would be helpful to give investors better information on what the agencies think about their true level of risk.

Ironically, Standard and Poor’s has assessed this question on behalf of the two companies. Specifically, they have evaluated whether the hybrids qualify as “equity” rather than “debt”, so as to reduce the companies’ riskiness (obviously at the cost of the holders of the hybrids).

In short, the more equity and the less debt the company has, the safer it is considered to be. This is because “equity” shares in the upside and downside risk of any company’s future. When things go bad (good), equity usually falls (rises) in value.

What investors in these hybrids may not fully appreciate is that Standard and Poor’s have given the Origin hybrids a 100% equity “credit” (ie, they are as good as normal equity for Origin) and a 50% equity “credit” for the Woolies hybrid.

It would appear that these instruments have been designed expressly for this purpose: ie, they pay investors a debt-like return, but lump them with equity-style risks.

Indeed, since the hybrids count as part or whole equity on the companies’ balance-sheets, they may actually help lower the interest rates the companies pay on their normal, senior-ranking debt.

In this context, Standard and Poor’s classify hybrids with “high” equity content as those having “very strong equity-like characteristics. They include features that help...improve the overall quality of the issuer's capitalization. Investors in "high" issues typically bear equity-like risk, and we would expect the value of such instruments to have a high correlation with the value of equity.”

Investors in the hybrids are likely subsidizing the companies’ cost of funding in two ways: first, despite their equity features, the cost of the hybrid funding is below the companies’ cost of equity; and, second, the fact that the rating agencies think the hybrids increase the amount of equity funding the companies have on their balance-sheets makes them a less risky concern, which can help lower interest rates on their traditional debt.

Superficially, there are some positives with these investments: they are both issued by companies that have strong competitive positions in their respective industries and solid credit ratings; they are listed on the ASX and thus offer some level of liquidity; both have small minimum investment sizes; and since retail investors arediving into them, it is possible that the hybrids’ required interest rate post-listing will be lower than their current interest rates, which means they could actually appreciate in value and deliver investors capital gains.

How do the returns the hybrids offer stack up against other alternatives?

Woolies priced at a margin of 3.25% above the 90 day bank bill rate, which implies a total return of 7.85%. In contrast, Woolworths’ shares are currently yielding 7.1%, but with the benefit of keeping all the equity upside.

Origin is proposing to price at around 4.25% over bank bills, which means a total return of about 8.85%. Origin’s shares are currently paying a dividend yield of just under 5% with the prospect of significant capital gains if its LNG investments pay off (and risks if they do not!).

The most revealing comparisons, however, are with the traditional subordinated (ie, emphatically not “hybrid”) debt securities offered by listed Australian banks and insurers.

While these issues are unlisted and have a minimum investment size of $500,000, they actually offer comparable, or better, returns (or “trading margins”) with materially lower risks than the hybrids.

I can think of at least three companies that have issued subordinated, floating-rate bonds that are outstanding in the market today. The margins generated by these issues are between 3% and 5% above the swap rate.

None of these companies have the right to defer paying interest for five years—any failure to do so would be an event of default, against which investors could take action.

All these subordinated notes are rated “investment grade” by the rating agencies, which means that there are no hidden equity risks.

Finally, the term of these loans tends to be much shorter, which suggests you have less risk of something going wrong compared with the 25-to-60 year terms under the hybrids.

The bottom line: retail investors and their advisors should exercise considerable care when thinking about investing in complex hybrid instruments that carry equity hazards.