As investors consider surging corporate debt costs since the beginning of the year, equity as a funding tool is now starting to look comparatively cheap. In fact, the relative cost of equity for shareholders (as defined by the dividend yield) over the cost of debt is the cheapest it has been since 2012 (see figure 1 below).
While it is more likely that corporates will first conduct cash tenders with excess cash on hand¹, we think this current relative cheapness of equity vs. debt may also offer opportunistic openings for selected issuers, notably in more cyclical industries as well as firms disproportionately impacted by current macro events (e.g., Russian gas exposure, which demonstrates high correlation with rising rates).
Deleveraging efforts through equity could help such firms weather an upcoming downgrade cycle on recession fears and cushion potential weaker credit metrics in 2023.
Figure 1: Bloomberg EuroAgg Corporate Index YtW vs. Stoxx Europe 600 Dividend Yield
The data shows it has never been this cheap to raise equity relative to debt in Europe since 2012.
More liability management of hybrid capital
Interestingly, in early July we saw a private Swedish Real Estate issuer arbitraging its cost of hybrid debt with its cost of equity via a cash tender on its heavily discounted hybrids. This was funded by an equity raise.
We think more transactions of the sort could come to the fore as the sell-off in the hybrid debt market has been brutal and more pronounced than in the equity market, notably in Real Estate and Utilities.
To screen for potential ‘hybrid into equity arbitrage’ candidates, we look at the cost of equity (CoE) of hybrid issuers (from the WACC² function on Bloomberg) and subtract the cost of hybrid debt, as defined by the yield to call (YtC).
Given convention is to price corporate hybrids to first call (and not to maturity); a higher cost of hybrids to first call (the YtC) than the issuer’s internal cost of equity (the CoE) means an issuer can assuage market’s leverage concerns by replacing part of its hybrid capital layer by equity.
From a rating perspective, replacing a like-for-like nominal amount of hybrid debt by equity is considered a deleveraging event, given that rating agencies only assign 50% of equity credits to a corporate hybrid issuance whereas equity inherently receives 100% equity credits.
At present, this arbitrage opportunity is available for selected Real Estate hybrid issuers that have sold off heavily in the face of rising rates, as well as for Utilities hybrid issuers in face of the ongoing European energy crisis.
Interestingly, reverse US hybrid issuers (a US corporate tapping the EUR-denominated standardised corporate hybrid market) also have such opportunities, which may be technically driven and resulting from a lack of coverage by European investors.
Figure 2: Examples of corporate hybrids for which hybrid into equity LMEs* would work
*Liability management exercises
1 As at 18 July 2022, Cash & Equivalents represents ~40% of total gross debt for Stoxx EUR 600, which is significantly higher than the ~23% pre-covid numbers from 1 January, 2020. Corporates have been operating with more cash on hands post-Covid.
² WACC stands for weighted average cost of capital.