S&P Global Ratings continues to see innovations in hybrid capital documentation. These innovations often provide certain protections to the subordinated hybrid investors, but could affect the issuer's incentives or financial flexibility in some stress scenarios. They could also weaken the equity-like protections that the hybrids provide for senior creditors and overall issuer creditworthiness.

We have recently received questions about how various features of hybrid capital instruments, such as coupon floors, different levels of subordination, restrictions on deferral periods, change-of-control clauses, and replacement intention language affect our view of a hybrid's equity content. The equity content determines how we take account of the hybrid when calculating the issuer's financial metrics.

In this Credit FAQ, we discuss how we use our hybrid capital criteria to assess the impact of issuing hybrids with such features. We focus on hybrids that have intermediate equity content because very few long-dated hybrids have high equity content. Examples of hybrids with high equity content include certain short-duration mandatory convertible securities and some government-owned hybrids.

FREQUENTLY ASKED QUESTIONS

Coupon Floors

What is a coupon floor and what effect does issuing a hybrid with a coupon floor have on an entity?

A coupon floor limits how low a coupon can go on a predetermined reset date when the coupon is recalculated based on market rates. Coupon floors haven't been a common feature of hybrids historically, but certain interest rate outlooks may make them more attractive to some investors.

We see a hybrid with a coupon floor as giving the issuer weaker protection than an equivalent hybrid without a floor from scenarios in which interest rates have fallen but refinancing is difficult. This is because the coupon floor would make it more expensive for the issuer to keep the instrument on its balance sheet if for any reason it was not practical to issue a replacement instrument when the reset date arrived (for example, because the hybrid market was temporarily closed, or the issuer was under credit stress). At the same time, the issuer receives no protection against higher interest rates.

The potentially higher cost may increase the issuer's overall financial incentive to redeem the hybrid. However, we would see this higher cost as a direct result of the issuer's choice of instrument structure and would not consider it a reason for the issuer to redeem the hybrid without replacing it. An extensive use of floors could affect our view of the issuer's financial policy and risk management.

How does a coupon floor affect S&P Global Ratings' view of a hybrid's equity content?

A hybrid with a coupon floor but no coupon step-up is typically still eligible to be classified as having intermediate equity content, unless the floor alters our view of the issuer's intention to use the hybrid's equity-like features in a stress scenario, or unless we consider that the floor creates a material incentive for the issuer to redeem the hybrid early.

However, we don't expect to assign intermediate equity content to a hybrid that combines a coupon floor with a coupon step-up or step-ups, unless the floor is set specifically to address situations where interest rates approach zero. Combining floors and step-ups typically adds complexity and can increase the issuer's incentive to redeem the hybrid due to the increased servicing cost in various scenarios. This is in line with the following paragraphs from our hybrid capital criteria, "Hybrid Capital: Methodology And Assumptions," published Feb. 10, 2025.

Why are coupon floors attractive to hybrid issuers?

Coupon floors reassure hybrid investors that the coupon rate will not fall below a specific amount on a reset date. This can protect hybrid investors against lower interest rates on the reset date, while still providing them with a higher coupon if interest rates are higher on that date. This additional reset cost to the issuer may also influence the investor's view of how likely the issuer is to exercise an optional call option around the reset date.

The initial coupon rate on the hybrid could be lower than if the same hybrid did not have a coupon floor because investors may be willing to accept a lower initial coupon on the basis that they are protected against it resetting below a specific level. This could be a way for the issuer to recoup some of the cost of providing the investors with protection against a lower coupon reset rate.

A lower initial servicing cost is helpful for an issuer, but the potential price differential between this cost and that of a hybrid without a coupon floor is still unclear because there are limited case studies. We have seen various market estimates that the price differential could be from anywhere from five to 25 basis points. A lower initial cost also doesn't prevent the issuer from having a greater incentive to redeem the hybrid on a future reset date.

Hybrid cash interest payments can typically be stopped or deferred either at the issuer's discretion, or in response to specific financial triggers. This ability to stop paying cash interest is one of the key reasons why we consider hybrids to be equity-like. However, with a floor, signals could be mixed. The coupon floor signals to hybrid investors that they will be protected against a lower coupon rate even though the coupon is entirely deferrable and they could get paid no coupon at all.

How does a corporate issuer's intention to replace a hybrid affect equity content under S&P Global Ratings' criteria?

We assign intermediate equity content to a corporate hybrid if we expect that it will be replaced with an equivalent or stronger form of equity before redemption. This is the case except in various scenarios, such as when the issuer's creditworthiness has improved, or when the redemption amount is immaterial in the context of the capital structure (see "Credit FAQ: How We Look At Corporate Hybrid Call And Replacement Decisions," published June 8, 2022, for more details).

If these scenarios don't apply, we expect an issuer to only redeem the hybrid if it can replace it. We wouldn't consider the cost of a high-floored coupon to be a reason for the issuer to redeem the hybrid without replacing it. Such a coupon cost would be a direct result of how the issuer had chosen to structure the hybrid.

Isn't a hybrid with a coupon floor effectively the same as a fixed-rate coupon hybrid where the coupon never changes?

A reset hybrid with a coupon floor looks like a fixed-rate coupon hybrid when interest rates fall. However, a fixed-rate hybrid protects the issuer against rising interest rates, whereas a reset hybrid with a coupon floor does not.

Does the specific nature of the floor make a difference?

Yes, it can. We've seen some floors set specifically to address situations where interest rates approach zero, for example in Japan. Such floors prevent unintended consequences such as negative coupon payments. However, more recent floors have been set close to or at the initial coupon rate. These types of floors protect hybrid investors more generally against a fall in interest rates and therefore may have a greater impact on the issuer's incentive to redeem the hybrid in certain scenarios.

Some floors may apply on every reset date over the life of an instrument, whereas others apply only on a specific reset date and therefore may have a more limited impact.

Degrees Of Subordination

Do you differentiate between hybrids based on their level of subordination?

No. It makes no difference to our rating analysis if an issuer has two hybrids that are the same except that one is more deeply subordinated than the other. Both instruments are junior to senior debt obligations and rank ahead of common equity.

We do not deduct additional notches for different degrees of subordination when assigning issue credit ratings to hybrid instruments. This is because the likelihood of default is the dominant driver of our ratings.

Length Of Deferral Periods

Does it matter if the issuer can only defer coupons for a limited period?

Yes, it does. We have recently seen increased use of limited deferral periods among corporate issuers, for example, clauses where a failure to pay deferred coupons after a period of five years would constitute a contractual default. We assign no equity content to a deferrable hybrid if the issuer is not able to defer payments for at least five years. We consider that five years is typically sufficient time for a distressed issuer to either recover or restructure its liabilities. For this reason, we can still assign intermediate equity content to a hybrid if the issuer must restart payments on a set date after five years.

However, we would typically reclassify such a hybrid as having no equity content if the end of the deferral period is approaching and the issuer is still experiencing credit stress. This is because the issuer would be obliged to pay the deferred amounts even if it was still under stress, and this may raise the risk of default.

Nature Of Replacement Intention Language

Does S&P Global Ratings expect an issuer to include any specific form of replacement intention language in its hybrid documentation?

No, we do not expect an issuer to include any specific form of replacement intention language in the instrument documentation. We review (but do not draft or approve) any replacement intention language that an issuer has decided to include and assess whether, in line with our criteria, that supports our view of whether an issuer intends to use the hybrid to absorb losses or conserve cash in a time of stress, and whether the issuer intends to replace the hybrid before redeeming it. We recognize that replacement intention language is not legally binding, but we see it as a supporting element in our assessment of issuer intent. Our criteria outline certain circumstances in which we don't expect an issuer to replace a hybrid, but we don't expect issuers to include any specific caveats or statements in any documentation.

Coupon Step-Ups In The Event Of A Change In Control

How does S&P Global Ratings view hybrids with clauses that increase the coupon rate if a change-of-control event occurs?

We've seen an increase in the number of hybrid instruments whose documentation contains clauses that lead to a coupon step-up (typically of 500 basis points) if a change-of-control event occurs. We consider that the occurrence of such a step-up would increase the obligor's incentive to redeem the instrument. We see such hybrids as providing weaker protection to senior creditors in some stress scenarios than hybrids without such a step-up clause, but we can still assign intermediate equity content if a change-of-control event is not anticipated.

This is because a change of control is one of the types of external situation cited in our criteria whereby we would maintain the equity content on an issuer's other existing and future hybrids if the issuer were to redeem a hybrid without replacing it beforehand. Entities often adjust their financial policies and balance sheet structures when a change-of-control event occurs, and our rating analysis would then focus on the creditworthiness of the entity under its new ownership.

Although hybrids with this type of step-up clause still qualify for intermediate equity content (assuming they aren't issued when a change-of-control event is expected), we see several risks for senior creditors because of the step-up clause. If the coupon does step up--typically immediately after a change-of-control event occurs--this would increase the company's servicing burden and therefore its incentive to redeem the hybrid. Both of these eventualities would divert resources away from the senior creditors and toward the junior hybrid investors. We therefore expect to remove equity content from such a hybrid once we believe that a change-of-control event is likely.

Related Criteria

• Hybrid Capital: Methodology And Assumptions, Feb. 10. 2025

Related Research

• Credit Implications Of Hybrid Noncall Decisions, Nov. 24, 2022
• Credit FAQ: How We Look At Corporate Hybrid Call And Replacement Decisions, June 8, 2022