DBRS Morningstar's Takeaways from Its 2022 Credit Outlook Series: How We Rate Corporate Hybrid Instruments

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed during its 2022 Credit Outlook series. In the session titled “The Rating of Corporate Hybrid Instruments” Michael R. Rao, CFA, Managing Director at DBRS Morningstar, outlined the company’s criteria for rating these instruments.

According to Rao, the issuance of hybrid securities—financial instruments that combine both debt and equity characteristics—has outpaced preferred shares recently, adding there is a wide variety of hybrids combining numerous features in the marketplace, with new versions emerging from time to time.

These instruments are attractive to buyers and sellers for different reasons.

“Companies issue hybrid securities largely because they attract a degree of equity treatment from rating agencies without diluting the ownership interests of their common shareholders and debt treatment from tax authorities whereby the associated interest expense is deductible for income tax purposes,” Rao said.

Meanwhile, investors are attracted to hybrid securities because they have a higher interest coupon and relatively small incremental credit risk, compared with senior unsecured debt, he added.

DBRS Morningstar assigns equity weightings to hybrid securities, ranging from 0% to 100%, based on their equitylike characteristics, with the most common equity weighting presently at 50%. Its two-stage process combines primary and additional factors to determine the equity weighting and caps the combined equity treatment assigned to preferred shares and hybrid securities at 10% of total capital.

Rao said DBRS Morningstar uses hybrid security equity weightings to adjust debt and equity levels in its leverage metrics calculations, such as the debt-to-EBITDA, cash flow-to-debt, and debt-to-capital ratios. However, in most cases, DBRS Morningstar does not adjust the interest expense of hybrid securities when calculating coverage ratios, such as EBITDA interest coverage.

DBRS Morningstar expects the interest expense of the hybrid securities to be paid, unless an issuer decides to exercise its deferral rights under the instrument. “DBRS Morningstar believes that all interest expenses that are paid should be captured in its interest coverage ratios,” he said.

To determine the equity weighting of a hybrid security, Rao said DBRS Morningstar measures the characteristics against the attributes of common equity including its subordination to all other creditors, permanence in the capital structure, and tolerance for missed scheduled payments without causing a default or cross-default to debt instruments.

“Permanence is an important characteristic of common equity that provides a cushion for senior debtholders in challenging times,” Rao said. “We believe this cushion should be in place for sufficient time as the issuer deals with tough times.”

Most hybrid securities are rated two notches below the Issuer Rating as they are deeply subordinated. Because of this subordination, the lender agrees it will not receive any payments until the senior lender has been paid in full.

However, there are cases when DBRS Morningstar will not assign equity treatment, including if the hybrid is not subordinated to senior unsecured debt, if the assumed remaining term to maturity is less than five years, or if the issuer cannot defer interest payments for at least two years.

Rao said hybrids usually include an issuer optional redemption feature at the 10th year (Noncall 10), although some five-year noncalls have also been issued. He added the issuer’s intention to replace the hybrid security upon early redemption with an instrument with equal or greater equity treatment than the original hybrid is critical for the “assumed remaining term to maturity” to move beyond the first call date.

Additional considerations in the final equity weighting analysis include acknowledgement of senior debt and subordination, events of default and covenants, and voting rights if they are material.

DBRS Morningstar bases its decisions on its methodology “DBRS Morningstar Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers,” published in October 2021.

Written by Scott Anderson

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