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When Debt Is More Than Debt

Before going into hybrid securities, investors owe it to themselves to investigate more than what may be apparent on the surface.

What is debt? That’s easy. It is an amount of money that is owed to another person or entity. So, then, what is equity?

Equity is more difficult to define than debt, but for the sake of simplicity, let’s lean on one of Investopedia’s six definitions: “A stock or any other security representing an ownership interest. This may be in a private company ... in which case, it is called private equity.”

One is a claim on cash, and one is a claim on ownership. Fair enough. What, then, is an undated six-year noncall deeply subordinated guaranteed fixed-rate reset security? An aspect is that the holder of such a security has no claim of ownership. Also, the upside of such a security is limited because of the call feature. So that would mean it is debt.

What if the issuer of this particular security were allowed to defer the debt service costs, say, to not make the coupon payments and allow them to accumulate? In addition, although there is a call feature, the issuer of just such a security — in this case, Spain’s Telefónica — has no obligation to pay the lenders back. Ever. That feels like equity. These Telefónica perpetual bonds — and other securities like them — are hybrids. Are they deeply subordinated debt or senior equity? Or are they both? These are examples of the existential questions facing the International Financial Reporting Standards at the moment. As investors, we must take a view on these kinds of securities every day, especially now that the valuation gap between hybrids and their reference senior bonds has rarely been greater.

According to its reading of the International Financial Reporting Standards, Telefónica includes nearly €5 billion ($5.57 billion) of perpetual securities as equity on its balance sheet for reporting purposes. The interest expense flows through the consolidated statements of changes in equity as retained earnings. On the cash flow statement — the most important statement to debt investors — Telefónica does not run the cash payments through the cash generated by the operations segment, but rather in the financing section, where the cash flow statement picks up dividend payments. Because Telefónica accounts for its nearly €5 billion in perpetual bonds as equity, those securities are excluded from the debt component of the all-important financial leverage ratio, net debt-to-EBITDA, which deflates that number. Meanwhile, rating agencies do not classify these equitylike debt securities as pure debt.

At Hermes, for analytical purposes we treat all corporate hybrids as debt and the debt service payments as cash interest expenses. Our rationale is that the market expects that issuing companies will service the obligations as if they were debt, and refinance the bonds at the first call to avoid punitive step-ups in interest costs. The bigger challenge for us is to determine if we are being compensated appropriately for the typical subordination of hybrids and the features that give them the qualities of an equity. To do that, we use a company’s senior securities as a foundation to build up premiums for the subordination and features. Then we compare those with what we see in similar securities. Needless to say, we want to avoid being simply paid like a lender when taking equity risk.

Fortunately, in the case of Telefónica, this is all relatively easy to track, thanks to Telefónica’s detailed financial disclosure. Nonetheless, as analysts and investors, we cannot take the company’s treatment of hybrids at face value and are compelled to ask questions of the company and make appropriate adjustments before we can price these instruments.

Hybrids are obviously important financial tools to companies, because they are used to raise capital that navigates the narrow straits between equity dilution and credit-rating degradation. Their popularity is evidenced by the surge in issuance over the past ten years: There are some €110 billion of hybrids outstanding. When one puts that number in the context of Bank of America Merrill Lynch’s European currency nonfinancial high-yield constrained index of €250 billion in market capitalization, or even the total €1.16 trillion market capitalization of the Bank of America Merrill Lynch euro nonfinancial index, these securities’ importance is clear.

Although standardization of such nonstandard sources of capital has increased, one cannot take a homogenous view on hybrids. Blanket statements like “I don’t like hybrids” or “I only like hybrids that are rated investment-grade” do not address the idiosyncrasies of each issuance. Credit investors must take a careful and considered view on these securities, both in terms of making an accurate assessment of a company’s capital structure and in terms of ensuring that one is paid appropriately for the risks being taken on — because failing to do so puts performance at risk.

Mitch Reznick is co-head of credit at Hermes Investment Management in London and a member of the capital markets advisory committee of the IFRS Foundation.

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