SSE bond reopens European hybrid market – but investors sceptical over deal terms

Scottish and Southern launched a UK corporate hybrid bond in September, paving the way for a flurry of European deals. But not all investors are impressed with the new hybrid issues

Scottish and Southern's Monar hydroelectric power station

September saw the reopening of the corporate hybrid market in Europe, with Scottish and Southern Energy’s £1.2 billion-equivalent issue followed in quick succession by deals from other utilities across Europe.

Prior to the UK company’s offering, the market for corporate hybrids had remained dormant since state-owned Dutch utility TenneT issued in February. Other potential hybrid issuers had been unwilling to launch deals while they awaited revisions to equity credit criteria by Moody’s Investors Service.

According to Gavin Kirkpatrick, vice-president of capital structuring and advisory at Royal Bank of Scotland, which jointly structured the SSE deal along with Barclays Capital, the publication of the new Moody’s criteria in July was enough to spur utility borrowers into action.

“We were aware in spring of a few issuers who were closely considering hybrid issuance, and who have now been able to look at the criteria, and have reacted,” he says. “As it stands, the major criteria for achieving 50% equity credit seem relatively palatable to issuers and investors alike, and that has helped issuers to proceed with their plans.”

Going, going, gone

The rating agency’s equity credit criteria are now based on the extent to which hybrid securities offer loss absorption for an issuer as a ‘going’ concern (where losses are absorbed “well in advance of a broad, company-wide default”), and as a ‘gone’ concern (where losses tend not to be absorbed unless a default is imminent). Securities that are more likely to absorb losses on a going concern basis rather than a gone concern basis are eligible for a higher equity credit rating, and vice versa.

“Thanks to clear definitions by Moody’s the game plan is now clearly established in the corporate hybrid market, even if there is always some little twist on it,” says Philippe Bradshaw, London-based managing director of syndicate at RBS.

Launched on September 8, SSE’s dual-tranche sterling and euro issue was not only the first hybrid deal since the Moody’s criteria revision, but the first ever to be launched by a non-state owned utility company. In addition, it was the first hybrid issue by a UK corporate since June 2007.

Twin tranches

The £1.2 billion-equivalent deal was divided into a £750 million sterling tranche, and a €500 million euro tranche. The sterling tranche carries a nominal coupon of 5.453%, equivalent to a launch spread of 355 basis points over five-year gilts, while the euro tranche has a coupon of 5.025%, equivalent to 315bp over five-year mid-swaps.

“We thought looking across two currencies would give SSE the flexibility to increase the size of the deal if needed,” says Wayne Hiley, head of European corporate syndicate at Barclays Capital. (SSE originally aimed to raise a minimum of £700 million.)

The hybrid securities are subordinate to all of the company’s outstanding bonds, and are ranked senior only to ordinary share capital. The transaction was rated Baa2 by Moody’s, and BBB by Standard & Poor’s, two notches below Scottish and Southern’s senior debt ratings of A3/A-.

The deal is perpetual, with securities callable after five years and 10 years, and then annually on each interest payment date. In addition, the securities can be called at any time if a ‘special event’ occurs, including a change in relevant tax law, a change in accounting principles preventing the securities counting as equity, a capital event preventing the securities being eligible for the same or higher equity credit, or a change-of-control event, accompanied by a downgrade of SSE’s senior rating to sub-investment grade.

Interest on the securities is deferrable at SSE’s option, on condition there has been no dividend or share buyback in the preceding three months. Deferred interest is accumulative.

If the deal is not called at the first call date, the fixed rate of interest will be reset to the then current five-year swap rate, maintaining the same credit spread over swaps as in the first period. From the second call date, the interest payments switch to floating rate and step up by 100bp.

The issue qualified as 50% equity credit with S&P, and was designed to also qualify for 50% equity capital with Moody’s. However, in line with its new methodology, Moody’s is yet to publicly notify any equity credit, and will not do so until it issues its next report on SSE.

RBS’s Bradshaw says the boost to equity capital will help support SSE’s credit rating. “It is a company that is very keen to keep its rating at the single-A level, and this product is perfect for giving comfort to the rating agencies,” he says. 

In order to qualify for equity credit, SSE has entered into a replacement capital facility, requiring it to replace the securities with an equivalent amount of equity in the 12 months prior to redemption, should it choose to call them. However, this only comes into effect the day after the first call date, so SSE could redeem the securities at the five-year mark without replacing them.

Pricing precedent

The pricing of the deal was in line with a similar issue by state-owned Dutch utility TenneT in February (the first, and up until SSE, only hybrid issue of 2010). The Dutch company’s €500 million hybrid featured two fixed rate periods, a 100bp step-up after the second call date, a deferral option, and a replacement capital covenant. On September 21, the bond offered a yield of 5.233% in the secondary markets.

In terms of investor type, Barclays’ Hiley says: “There were more hedge funds, because it is a higher yielding instrument than senior debt. But the investors in this deal were mainly the same real money asset managers that would buy a senior transaction.”

The deal’s two tranches have so far met with varying fortunes in the secondary market. On September 21, the sterling bonds had widened to yield 5.472%, or 361bp over five-year gilts, while the euro notes had widened to 5.088%, or 362.8bp over Bunds.

Both tranches of SSE’s deal were oversubscribed: orders for the euro piece totalled €1.8 billion in comparison with £1.7 billion for the sterling book. In the end, there were around 150 different investors in each of the books, with over 90% of buyers in the sterling tranche from the UK. For the euro tranche, roughly half of the bonds were sold to UK accounts, while 25% went to German and Swiss investors. The rest went to buyers elsewhere in Europe.

“This trade is an illustration of a trend we have seen over the last few months towards greater risk appetite,” says Bradshaw. “For investors, it is a trade-off between the additional risk of taking on bonds that are subordinated to the outstanding senior paper, and the additional yield.” SSE currently has several senior issues outstanding, including a nine-year £500 million bond and a five-year £700 million bond, both completed last year.

In the pipeline

Regardless of the debate on whether the SSE deal offered good value, investors were not deterred from participating in the flurry of similar deals that followed.

“The window is now open, and you will see more issues,” says Jim St Johnston, co-head of fixed income investment banking at Matrix Corporate Capital, based in London.

After SSE completed its deal, French utility Suez Environnement came to market with a €750 million perpetual NC5/NC10 50% equity credit hybrid, while Australian oil exploration and production company Santos sold a €650 million 60-year/NC7 100% equity credit hybrid deal.

While Suez Environnement is a frequent issuer to the European market, Santos has never previously issued Eurobonds. Its deal was considered the acid test for investor appetite, with Barclays’ Hiley suggesting it “could open the market to lower-rated credits”.

On September 21, German electricity and gas utility RWE completed a €1.75 billion hybrid – the largest deal of its kind in euros. The securities are treated as 50% equity credit by both S&P and Moody’s and are rated Baa1/BBB+, two notches below RWE’s senior credit ratings.

The transaction is structurally similar to SSE’s, being perpetual, with optional issuer calls at par in years five and 10, and at every coupon payment date thereafter. Interest payments are optionally deferrable, and are cumulative, but non-compounding. Highlighting the scramble for yield as September drew to a close, RWE’s deal carries a coupon of just 4.625%.

“Utilities are the kind of names that fit most naturally into the corporate hybrid structure. In terms of its robustness and steadiness, the utility business lends itself more naturally to a subordinated deal,” says St Johnston.

RBS’s Kirkpatrick says that with the uncertainty surrounding ratings overcome, 2010 could be a record year for hybrids. “We are already approaching volumes that have not been seen since 2005. I think we could see more issues in 2010, with one of the highest – if not the highest – levels of hybrid corporate issuance in a calendar year.”

Buyers' verdict

The Scottish and Southern hybrid has received a mixed reaction from investors. Some have questioned the relative value of the deal, saying that if market participants are happy with the greater risk exposure, they would do better to simply purchase equity and benefit from the higher returns that would give them. (SSE’s most recent dividend yielded just over 6%.)

“If you want to take the equity risk, just go and take the equity. You get paid more for it,” says Richard Ryan, director of fixed income at M&G Investments in London, who called the Scottish and Southern transaction “a rotten deal for investors”.

Ryan believes investors in the subordinated bond receive little additional protection to compensate for the lower yield vis-à-vis equity. “The call feature is pretty weak. What you have really got palmed off with is all the negative equity features and all the negative equity risk, and none of the upside,” he says.

Andrew Moulder, utilities analyst at CreditSights, wrote in a September 3 report entitled SSE: Yield Should Make New Perpetual Attractive: “The expectation is the security will be called at the first call date, but this is not a company commitment.”

Moulder added that as a publicly traded company – in contrast to the state-owned companies that have previously issued hybrid securities – it would be comparatively difficult for SSE to pass on its dividend, and defer coupon payments. In addition, the company has a strong track record of paying dividends.

Furthermore, SSE’s substantial upcoming bond maturities in 2013 and 2014 should increase the likelihood of prompt coupon payments, and of the bond being called at the five-year mark. Moulder wrote: “It will need to access the debt capital markets. We would expect SSE to want to keep debt holders onside.”

A credit portfolio manager at a London-based investment house says: “Reputation is especially important for utilities because they are reliant on coming to the debt market. But I think the market is always going to be sceptical about that to some extent. What if SSE was taken over, or if there was a windfall tax on utilities? I do not see that as very likely, but it is a possibility.”

M&G’s Ryan notes that even though there is a small possibility of the deal extending beyond five years, it is not so small that it should be dismissed completely. The potential for  rates to also begin to normalise in that time has not been properly taken into account, he adds.

“Even if it steps up at the first call date by a number of basis points, if yields have normalised you will not be able to replace it in your portfolio – at least not at a similar level. My job is to invest my clients’ money sensibly. A lot of investors had a very poor experience throughout the financial crisis with their subordinated bondholdings, and do not want a repeat of that,” says Ryan. 

The London-based credit portfolio manager attributes the deal’s oversubscription to record low interest rates. “People are absolutely desperate to get anything with a bit of yield,” he says.

Deal terms: Scottish and Southern
Issuer: Scottish and Southern Energy
Date of issue: September 8, 2010
Size of deal: £1.2 billion-equivalent
Structure: Subordinated
Maturity: Perp NC5/10 (step-up in yr 10)
Ratings: Baa2/BBB (Moody’s/S&P)
Joint structuring advisors: Barclays Capital, RBS
Joint lead managers: Barclays Capital, BNP Paribas, Credit Suisse, RBS 

Sterling tranche: £750 million
Coupon: 5.453%
Issue spread: 355bp over 5yr gilts

Euro tranche: €500 million
Coupon: 5.025%
Issue spread: 315bp over 5yr mid-swaps