Breakingviews - Funky debt bonanza is breeding complacency

  • 12/8/2020
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LONDON (Reuters Breakingviews) - The booming market for funky corporate debt is too successful for its own good. Companies from BP to Gazprom are issuing more bonds that count as equity than ever before. Low rates and investors’ thirst for yield explain why. Yet the market is missing the chance to come up with something more useful. So-called corporate hybrids are having a good crisis. Companies had raised a record 37 billion euros of them as of mid-November, 58% more than the same period in 2019, according to Refinitiv data. The securities don’t have a specific repayment date and allow the companies that issue them to defer coupons. They are also typically viewed by rating agencies as half equity and half debt. That explains their appeal. The damage caused by Covid-19 has made issuers more willing to explore ways to bolster their balance sheets rather than tap shareholders. With interest rates collapsing across the globe, bond investors are hungry for esoteric instruments in return for extra yield. Hybrid bonds will typically offer at least twice the spread - or premium over risk-free rates - available on a company’s plain vanilla debt. They can still be a good deal for issuers. Take BP’s inaugural hybrid, issued in June. It counts as half debt, half equity. Assuming a 10-year cost of debt of 1%, and the oil major’s 9% cost of equity estimated by Morningstar, it would cost around 5% to replicate a hybrid with traditional bonds and equity, before any tax benefit. Yet BP’s equivalent 2029 hybrid paid a coupon of just 3.6%. Put another way, its implied cost of equity was just over 6%, according to Breakingviews calculations. The snag is that hybrids aren’t anything like as useful as equity. Coupons can be deferred, but must still be paid. Companies face penalties if they don’t call the bonds when expected. Hybrids’ low coupons suggest that rating agencies are overstating their equity-like features. The risk is that companies are building up liabilities that are more debt-like than they appear. Instead, they could issue bonds that absorb losses more easily before a company fails, say by letting coupons be cancelled, not just deferred, when debt reaches certain thresholds. Investors would require a higher return. But with rates so low and demand for funky debt high, issuers could probably still afford it.

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