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A rare hybrid convertible bond in September 2016 by French metals and mining group ERAMET has demonstrated the attractions of the instrument and could prompt other unrated corporates to come to market, write Alexis Singer, Investment Banking and Dhiren Suares, Equity-Linked.
In a busy period for equity-linked issuance – €4 billion was raised in Europe last September compared to around €2 billion ordinarily – a hybrid convertible from French metals and mining group ERAMET stood out. The deal, while small compared to some other issues that month, is only the fourth hybrid convertible to have been issued in recent years. It highlighted the benefits of these unusual equity-linked instruments and could pave the way for similar deals from unrated mid-cap corporates.
Hybrid convertibles remain rare because many of the companies large enough to come to the capital markets are rated. Consequently, they choose to issue straight hybrid bonds, which are structured to receive equity credit from rating agencies (and support the issuer’s credit rating), rather than hybrid convertibles. However, as interest rates have fallen – and investor demand for yield has grown – unrated companies, such as ERAMET, have also spotted the opportunities offered by hybrid structures.
Hybrid convertibles notably offer the benefits of being treated as 100%-IFRS equity – primarily reduction of leverage on the balance sheet – without the disadvantages of immediate share issuance, such as diluting existing shareholders and earnings per share (EPS). They are particularly suitable for unrated companies as the criteria for equity treatment under IFRS accounting standards is less strict than that used by rating agencies. By adding the ability to convert to equity, hybrid convertibles also enable an issuer to achieve a coupon that is potentially hundreds of basis points lower than a straight hybrid.
While the universe of potential hybrid convertible issuers is limited given the relatively small number of sizeable unrated companies, for suitable corporates with market capitalisation of between €1 billion and €5 billion the structure is extremely attractive. The issue in September has helped to raise awareness: other issuers could follow suit.
The equity-linked market has enjoyed strong issuance volumes in 2015 and 2016, helped by record low interest rates and robust stock markets (partly supported by quantitative easing). Issuers have been eager to take advantage of terms that are among the most attractive ever for convertible and exchangeable bonds. Recent issues have achieved exceptionally low (or even negative) coupons and, in some cases, conversion premiums of up to 70%.
Like many companies in the metals and mining sector, ERAMET has faced significant challenges following the end of the commodities boom. With the price of the commodities it produces close to record lows – and production costs higher than market prices – ERAMET is in the process of implementing a significant cost optimisation plan: the deal in September offered a way for the issuer to tell the market that its plan was on track and core shareholders were supporting it.
Hybrid convertibles differ from regular convertibles because they are undated, carrying a perpetual rather than a defined maturity. In addition, coupons on a hybrid can be deferred at the issuer’s discretion without triggering a default. These features enable hybrids to be treated as equity under IFRS accounting rules. Another advantage is that they can be structured to offer the issuer the flexibility to settle the conversion option in any combination of cash or shares. As a result, shares underlying the bond are not included in EPS calculations and therefore dilution can be avoided.
With this issue, while ERAMET has the flexibility to defer coupon payments, the emphasis placed on expected benefits from the cost optimisation plan – and the condition that deferred interest must be paid in case of a dividend, for example – helped to instil confidence among investors that coupon deferral is unlikely. Investors were also encouraged by the strong incentive for the company to redeem the bond: after six years the bond’s coupon steps up to six-month Euribor plus 1,000 basis points.
The equity-linked market is likely to remain attractive for both issuers and investors, and further hybrid issues are a possibility. Many unrated companies are looking to improve their leverage metrics, such as net debt/ebitda and debt/equity, and access liquidity at a lower cost than the straight hybrid market.
In restructuring situations, hybrid convertibles – by emphasising the willingness of existing shareholders to stand behind the company – also enable the issuer to send a strong message to shareholders and the broader market that the company has got the situation under control. In the case of ERAMET, that message was clearly received by investors, as evidenced by a significant increase in its share price within weeks of the launch of the convertible.
Meanwhile, investors continue to search for higher yielding assets given the low interest rate environment. Although the coupon on ERAMET’s September’s issue was lower than the observed yield of the issuer’s outstanding plain vanilla bonds, it compares favourably with the yield available on many other asset classes. As a result, while much of the hybrid convertible issued in September was taken up by existing shareholders during a three-day priority subscription period, the remainder was successfully allocated to dedicated convertible funds and even some retail investors.Read more