Corporate Hybrids 2017 Handbook 2017 Handbook Credit Research Corporate Hybrids The BondAdviser Corporate Hybrid Handbook 2017 is designed to be a useful reference for ASX- listed corporate hybrid securities and the credit profiles of their underlying issuers. We believe Jack Pobjoy there are a number of attractive investment opportunities across different corporate industries and Credit Analyst the recommendation table below reflects our views on these particular securities. (+61) 3 9670 8615 [email protected] Corporate hybrids are overshadowed in a market dominated by banks and other financial Nicholas Yaxley institutions. As a result, many investors fail to reap the diversification benefits that non-financial Head of Research issuers offer in a balanced portfolio. While bank and other financial hybrids are often driven by (+61) 3 9670 8615 macro-economic, regulatory and/or political themes and trends, corporate hybrids warrant a more [email protected] case-by-case approach which promotes diversification. For this reason, corporate hybrids should not be overlooked. Given the ‘lower-for-longer’ interest rate environment, the search for yield is becoming an increasingly difficult task. While hybrids continue to be an attractive option to boost income, they are not without inherent risks. Figure 1. Summary of Recommendations Buy Hold Sell APA Group Subordinated AGL Subordinated Notes Notes (AQHHA) (AGLHA) Crown Subordinated Notes I Goodman Preferred Step- (CWNHA) Up Securities (GMPPA) Crown Subordinated Notes II Origin Energy (ORGHA) (CWNHB) Seven TELYS4 (SVWPA) Ramsay CARES (RHCPA) Woolworth Subordinated Notes (WOWHC) Caltex Subordinated Notes (CTXHA) Tabcorp Subordinated Notes (TAHHB) Multiplex SITES (MXUPA) Nufarm Step-Up Securities (NFNG) Source: BondAdviser Tatts Bonds (TTSHA), Peet Bonds (PPCHA) and Qube Subordinated Notes (QUBHA) are excluded from this report as they are not considered hybrid securities. 1 | Bond Adviser Pty Ltd Corporate Hybrids 2017 Handbook Table of Contents 3. Introduction: Why Corporate Hybrids 4. Hybrids: Debt or Equity? 5. Corporate Hybrid Characteristics 6. Corporate Hybrids Structure Summaries 7. Valuation 8. Market Size 9. Historical Risk and Return 12. Market Performance 16. Outlook: Top Trades 19. Company Profiles AGL Energy APA Group Caltex Australia Crown Resorts Goodman Plus Trust (Goodman Group) Multiplex SITES Trust Nufarm Origin Energy Ramsay Health Care Seven Group Tabcorp Holdings Woolworths 32. Appendix 1: Accounting Treatment of Hybrids 33. Appendix 2: Trust Structures 34. Appendix 3: Non-Called Hybrids 2 | Bond Adviser Pty Ltd Corporate Hybrids 2017 Handbook Introduction: Why Corporate Hybrids? Hybrid securities are instruments that feature characteristics of both debt and equity and are generally complex and highly structured instruments. A hybrid is the broad term used to describe an instrument that typically ranks behind senior debt but ahead of equity and in some cases can be converted into ordinary equity. However, they can incorporate numerous features that comprise either debt-like and equity-like traits. Why do companies issue hybrids? For some companies, it may be easier to raise debt instead of equity, especially for private companies that do not have access to capital markets. For others, it could be a case of cheap funding or tax benefits. Hybrids also allow companies to avoid common equity dilution which is a positive for earnings per share. On the other hand, companies may choose to issue hybrids over senior debt due to restrictive financial covenants that limit the amount of senior indebtedness the company can incur. Overall, the reasons behind hybrid issuance is diverse but will ultimately tie into the company’s overarching capital management strategy. Over the past 5 years, hybrid issuance has been a by-product of credit rating methodology known as ‘equity-credit’. Under this criteria, hybrid securities are classified (partially or wholly) as equity instead of debt from a credit rating perspective. This in turn maintains the underlying issuer’s credit metrics when assessed by the credit rating agencies. Equity credit typically ceases once a hybrid security reaches its call date. As a result, this gives the issuing company an incentive to call the security at this date unless the cost of servicing the hybrid remains relatively cheap to other funding sources (which is unlikely given the explanation below). By utilising the equity credit treatment companies incur higher interest costs (i.e. 2-3%) relative to normal debt instruments of bank funding. This is due to the capital structure and priority of payments, which differentiates traditional fixed income (i.e. bonds) from hybrid securities. Figure 2. General Corporate Capital Structure Low Risk Corporate Capital Structure Senior Secured Bank Loans Secondary Lien Secured Bonds Senior Unsecured Subordinated Debt Hybrids Preference Shares Equity Shareholders High Risk Source: BondAdviser Hybrids rank below senior debt and are therefore riskier investments. Due to this increased risk, hybrids will generally pay a higher return (as described above in the form in of a yield premium). It is therefore crucial that investor’s understand the underlying issuer’s capital structure to help justify the risk and return inherent in a potential hybrid investment. Additionally, as these securities are classified as a combination of equity and debt, they are generally more volatile than traditional debt instruments and behave in a manner similar to ordinary equity during periods of financial distress. 3 | Bond Adviser Pty Ltd Corporate Hybrids 2017 Handbook Hybrids: Debt or Equity? Hybrids can be classified as either debt or equity depending on varying accounting treatment and methodology (see appendix 1). However, the truth is hybrids exhibit both equity and debt characteristics and this is the foundation behind the equity-credit given to companies by credit rating agencies. In the following diagrams, we dissect a general hybrid’s structure to illustrate the overlay of debt and equity asset classes. Figure 3. Comparison of characteristics between hybrid instruments with debt and equity Hybrid Debt Equity Non-Deferrable Interest Optional Interest (Dividends) Cumulative Interest Payments Non-Cumulative Dividends Fixed Maturity Date No Maturity Date - Perpetual No Conversion Mandatory/Optional Conversion Unsubordinated Deeply Subordinated Source: BondAdviser Figure 4. Hybrid Security Spectrum Senior Debt Subordinated Debt with Perpetual non- interest deferral cumulative debt Ordinary Shares Subordinated Debt Subordinated Debt Convertible preference with loss absorption shares and capital notes Pure Pure Debt Equity Source: Australian Securities and Investment Commission (ASIC) 4 | Bond Adviser Pty Ltd Corporate Hybrids 2017 Handbook Corporate Hybrid Characteristics As previously mentioned, corporate hybrids warrant a case-by-case analysis. While all corporate hybrids are subordinated to senior debt and have some form of call date, there are unique security- specific characteristics that must be considered. Deferral Risk Many hybrids exhibit a mandatory or optional coupon deferral condition. This effectively means that the issuer may either be forced or choose to defer payments to hybrid investors. The interpretation of what can actually trigger a distribution deferral can include events such as a credit rating downgrade or breach of one or more financial covenants specified in the terms of the hybrid documentation. An important detail is whether the deferred coupons are cumulative and/or compounding or not. If the coupons are cumulative, hybrid holders may recoup deferred payments once the deferral event ceases. As a result, all missed coupon payments will be paid at the next payment date. If the coupons are also compounding, interest earned on deferred distributions will also be reimbursed to the investor. If the hybrid is non-cumulative, then deferred (or missed) distributions will never be repaid. If deferral occurs, the issuer may also be subject to a dividend pusher and/or stopper. Dividends stoppers ensure that all securities subordinated or on par with the hybrid (in regards to their position on the capital structure) are not paid distributions until payments are resumed on the hybrid (or in some cases until after a certain time period of resumed payments). Dividend pushers, on the other hand, ensure that before a dividend payment is made, coupons on the hybrid are being paid again. Step-Ups Hybrids may also be subject to various coupon step-up conditions. A feature of some hybrid securities is a pre-specified coupon step-up if the issuer fails to redeem the hybrid security at its call date. A coupon step-up could also occur if the underlying issuer experiences a credit rating downgrade or breaches a financial covenant. As the step-up will increase the funding cost, the issuer may have an economic incentive to call the hybrid as it may be replaced by a similar security (or even another hybrid) with more favourable terms (to the issuer). Callability The callability of a hybrid depends on its structure and term. The hybrid can either have a pre- specified call date, multiple call dates, callable over a pre-defined period or callable at any time. It is also worth noting that in some cases the call date is referred to as the reset date or the re- marketing date. At the call date, the hybrid may either be redeemed and/or converted into ordinary equity depending on the terms of the relevant