It's been a bad month for hybrids, and an even worse one for hybrid investors.
On November 2, Standard & Poor's (S&P) announced it was reviewing the equity classification of corporate hybrids issued by the likes of Origin, Tabcorp and AGL over the past year.
This would bring an end to the "100 per cent equity credit" currently given by S&P when reviewing the issuer's credit rating – a key reason for the hybrids being issued in the first place.
Then, on November 9, Bank of Queensland (BoQ) dispelled the popular notion that banks would redeem hybrids at the first opportunity (and against their economic interests), to protect their reputations.
In the real world, money talks.
BoQ has decided it doesn't make much sense to repay cheap debt when it doesn't have to, leaving investors in perpetual equity preference shares (PEPs), issued in 2007, high and dry. In effect, the bank is saying, "stuff the reputation risk, let's save some money".
Advisers and brokers have also been telling potential buyers that the corporate hybrids would be redeemed once the "100 per cent equity credit" expired at the early redemption date. Unlike reputation risk, this was a real economic incentive to redeem.
S&P have finally cottoned on to this fact, about a year too late.
No one should be surprised. The ratings agencies only worked out that slapping AAA-ratings on pools of securitised garbage was a bad idea once the GFC exposed it as such.
Hybrids are just another case of brokers and investment bankers working out the "game" on-the-spot, and the ratings agencies catching up once the game's almost up.
So what impact will S&P changing the rules (the amount of equity credit granted) have on corporate hybrids?
One argument doing the rounds is that a drop in equity credit will cause issuers to redeem early, reducing the risk to investors.
That's possible, but unlikely. Having spent millions getting these cheap equity deals away, issuers aren't going to lie down and cop a rule-change on the chin.
A lengthy submission and negotiation process is now under way.
Hybrid issuers, who, not incidentally, pay the ratings agencies bills, will be well-represented. But hybrid investors? There is no seat at the table for them.
The problem is that S&P's review means someone has to get screwed, and it's unlikely to be the people that pay S&P — the hybrid issuers. Step up please, hybrid investors!
A simple solution to S&P's concerns would be for issuers to undertake not to redeem the hybrids without first replacing them with equivalent capital. In return, S&P could probably grant them equity credit (even if at a lower rate) in perpetuity.
It's not in the interests of either the issuers, or S&P, for this cheap equity to be repaid quickly.
What does all this mean to hybrid investors?
Unless the hybrid boom continues, it's quite possible they'll end up holding a note for decades, up to 60 years in the case of Origin, with little prospect of early repayment.
Of course, the advisers and brokers who told investors "of course the issuer will redeem early, they always do" may feel a tinge of regret.
But by that time, they'll have moved on to selling something else.
Richard Livingston is the managing director of Intelligent Investor Super Advisor, an online service providing SMSF and investing advice. This article contains general investment advice only (under AFSL 282288).
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