Calling a hybrid capital instrument at an optional call date is no longer a straightforward decision. Increasing interest rates make it more difficult, and more expensive, for issuers to refinance existing hybrid capital. S&P Global Ratings therefore expects to see more noncall decisions by issuers, and more cases where issuers redeem a hybrid, despite not being able to replace it.

In a rising interest rate environment, noncall decisions are likely to be based on economic considerations and we regard them as credit-supportive. Issuers need to manage the carrying cost of their hybrids and the timing of refinancing. A hybrid that has not been called retains its financial benefits, even if we no longer regard it as having equity content.

Here, we examine the credit implications of an issuer choosing not to call a hybrid that originally had equity content. Details of how we view hybrid replacement decisions by corporate issuers are available in an earlier article, "Credit FAQ: How We Look At Corporate Hybrid Call And Replacement Decisions," published on June 8, 2022.

So far, the reputational effect of a noncall has been relatively short-lived. Previous noncall decisions have not damaged issuers' capital market access over time. That said, some issuers may face more of a pricing premium on future hybrid instruments than others.

Deciding Not To Call A Hybrid

In recent years, issuers have typically called hybrids on the first optional call date because it has been relatively easy to issue a replacement instrument at a cost that is in line with, or cheaper than, that of the original hybrid. Now that interest rates are rising and it is no longer possible to refinance hybrid instruments at a similar or lower cost, issuers have to apply a more detailed analysis. They must balance the financial impact of a more expensive refinancing against the potential reputational effect of not calling and replacing their hybrid instruments when investors expect them to.

We consider the potential for noncalls to be in line with what we typically see in a market downturn. As refinancing costs rise, we expect to see more cases where issuers do not redeem hybrids at call dates, or where they redeem despite not being able to replace the hybrid.

Hybrid capital instruments are designed to act like senior debt when credit conditions are good. They pay a known coupon and redeem on predictable dates. When credit market conditions weaken, their equity-like characteristics kick in. These characteristics include not exercising optional calls if that makes economic sense for the issuer. If it comes under severe stress, an issuer could even stop paying hybrid coupons.

The reality of these equity-like features could make some hybrid investors less willing to invest in future hybrid issuance, and increase the coupon they demand for taking the risk. That said, recent noncall decisions have not affected issuers' long-term access to capital markets and hybrids can't act like equity if they have to be called at each call date.

Flexibility Not To Call Is An Important Feature Of Hybrid Capital

We assign equity content to hybrids (that is, treat them as having equity-like characteristics in our financial metrics) when we consider hybrids are able to absorb losses or conserve cash when needed. It is essential that they be available on the issuer's balance sheet to perform this role. In assessing equity content, we focus on the flexibility to use the equity-like features of hybrids in stress conditions. These include generally stressed market conditions and stresses specific to the issuer.

Hybrid capital instruments that have call options give issuers the right, but not the obligation to redeem them, a key feature that underpins their equity content. The optional nature of the call provides an issuer with more flexibility to manage its capital and the timing of any redemptions or refinancings. If issuers did not have the flexibility to decide not to exercise a call, we would be unlikely to assign equity content to their hybrids in our ratings analysis.

The Issuer Isn't Breaking A Promise If It Decides Not To Call

Because the call is only optional, a noncall decision is not a default. The issuer never promised to pay the principal back at the optional call date. Even though market participants often refer to extension risk, the issuer has neither delayed repaying investors, nor has it extended the hybrid's maturity. The issuer is just not repaying these subordinated investors as early as they would like.

Hybrid capital carries a higher coupon than senior bonds; for example, a senior bond with a contractual maturity five years after the issue date will have a lower coupon than a hybrid issued by the issuer on the same day with a first call date in five years. This is to compensate holders of hybrid capital for the additional risks they take on, which include:

• Subordination;
• Deferability of the coupon;
• The potential for principal write-down or enforced conversion into common equity for some hybrids; or
• The possibility of a longer tenor, in case of noncall.

The coupon for some hybrids steps up or resets on a call date, which offers investors additional compensation if the instrument is not called. That said, the investor may not always see the increase as sufficient, in hindsight.

Reputational Effects Have Been Short-Lived

The current hybrid market conditions are not unprecedented, in our view. We saw similar increases in hybrid spreads and tough refinancing conditions during previous credit downturns, such as after the dot.com bubble and during the 2008 global financial crisis. That said, the recent rise in spreads and policy rates has been among the most rapid in the past decade. In addition, hybrids have become more widespread in some sectors and regions than they were before--for example, they are now used more widely in the EMEA corporates sector, where most issuers have structured them to lose equity content on their first call date. Although several Western European banks have made noncall decisions since 2016, market conditions have been so favorable that many investors have yet to see noncalls in their portfolios.

We understand concerns that, at least initially, a noncall decision could have a negative reputational impact for an issuer. That said, particularly in the current market conditions, we see noncall decisions as unlikely to signal specific credit strains at the issuer. In our view, they are typically credit-supportive, economically rational, financing decisions. We expect the reputational impact to be short-lived, as demonstrated by noncall decisions at banks such as Standard Chartered Bank (2016), Woori Bank (2009), Banco Santander S.A. (2019), Deutsche Bank (2008 and 2020), and Mizuho Financial Group (2009). In each case, the bank was able to access hybrid capital markets later, at a cost comparable with other issuers.

Noncall decisions by rated banks and insurers in 2022 have not led to market concerns about the creditworthiness of the issuers, have not damaged capital market access, and have been seen as economically rational decisions. Examples from Western Europe include Banco de Sabadell and Raiffeisen Bank International AG--other examples include the Canadian Bank of Nova Scotia and Bermuda-based SiriusPoint. Itaú Unibanco Holding S.A. became the first Brazilian bank to announce a noncall decision in October. It has stated that, due to economic factors, it will not exercise a December 2022 call option on its US$1.25 billion perpetual additional Tier 1 hybrids; this did not roil the markets. Entities that we do not rate have also announced noncall decisions, citing economic costs and market conditions.

Reputational or contagion concerns can be greater where a market is less used to seeing issuers use the flexibility built into a hybrid. For example, until the Nov. 1, 2022, announcement by Heungkuk Life Insurance Co. Ltd. (not rated) that it did not intend to exercise an optional call on a hybrid, South Korea had not seen a noncall decision since 2009. The market's response caused the insurer to reverse its decision not to call the instrument.

Choosing whether or not to call a hybrid could have implications for future financial flexibility. That said, we anticipate that specific issuers will see a more muted reputational effect if noncalls become more common in a particular sector, or if market participants understand how economic considerations are likely to affect issuers' noncall decisions. If an issuer is suffering from specific credit stresses, then a noncall decision can help conserve cash and ensure that the expected layer of hybrid capital is present and can help protect senior bondholders. Noncalled hybrids can provide long-term financing at a relatively competitive funding cost for a more stressed issuer, supporting its maturity profile and bolstering its overall creditworthiness.

Not Calling Hybrid Capital Protects Senior Investors

If an issuer decides not to call a hybrid, it escapes the need to refinance. The issuer can aim to wait out tough market conditions--redeeming and refinancing when conditions are more attractive. Of course, a noncall decision won't necessarily stop the servicing cost from rising. Many hybrid coupons step up at the call date, or reset to a floating rate--in the current market, this is likely to be higher than the previous fixed-rate coupon. However, this increase in servicing cost is not, in itself, more damaging to the issuer than other possible courses of action. Keeping the hybrid on the balance sheet after the call option date conserves cash and can provide more protection to senior investors than the alternatives, which are to:

• Issue a new hybrid, which would have an even higher coupon in the current market conditions;
• Redeem the hybrid and replace it with senior debt; or
• Redeem the hybrid without replacing it at all, which would have the worse effect on creditworthiness.

Thus, protecting the senior bondholders by not calling the hybrid can help underpin access to broader funding sources, even if those who invested in the affected instrument are unhappy.

A Noncalled Hybrid Without Equity Content Still Provides A Benefit

Even if we regard a hybrid instrument that has not been called as having no equity content because it now has a short residual maturity, it still provides a qualitative benefit in our rating analysis. The instrument remains a subordinated and relatively long-dated element of the balance sheet and, by deferring the coupon, the issuer could still use it to conserve cash. Indeed, the issuer has already shown that it is willing to use the hybrid to conserve cash and manage the timing of any refinancing. We factor this in when assessing the overall creditworthiness of the issuer, even if the headline financial metrics have deteriorated.

Many corporate issuers structure their hybrids so that we classify them as having intermediate equity content until the first call date. If they are not called, they would then typically have no equity content. When we classify a hybrid as having intermediate equity content, we apply 50% of the value as equity and 50% as debt in our credit ratios. If it has no equity content, we treat the entire value of the hybrid as debt, which weakens our credit ratios.

Issuers may worry that the removal of equity content will trigger a downgrade. However, in our analytical approach, there is no automatic link between our rating decisions and the removal of equity content on any or all of an issuer's hybrid instruments due to a noncall. Equity content may influence our view of capital or leverage, but it doesn't necessarily change our view of overall creditworthiness. This approach also applies to dated insurance and bank hybrids--we still recognize the qualitative benefits of a hybrid that has no equity content under our criteria, when assessing capital.

Regulatory Considerations May Influence Call Decisions

For banks and insurers, economic decisions about the relative cost of refinancing are not the only concern. Prudential regulatory considerations also come into play. If a hybrid forms part of an issuer's regulatory capital, a bank or insurer may only be able to call that instrument if its regulator agrees, or doesn't object. Banks and insurers must ensure they remain sufficiently capitalized from a regulatory perspective. If they do not have sufficient regulatory capital without the instrument, they typically cannot call it without replacing it with another of the same or a higher quality.

In our view, many regulators are in favor of regulated financial services entities making economically rational decisions when interest rates are rising--even if this means an increased number of noncalls, and faster repricing in the hybrid capital markets. Generally, regulators are clear that banks and insurers should not intimate or promise that they will exercise a call option. They want issuers to retain the flexibility not to exercise a call.

Before the 2008 global financial crisis, bank investors always expected calls to be exercised. The market's response to the first noncall decisions in 2008 caused banking regulators to reform Tier 1 hybrids to exclude hybrids that had step-ups or similar incentives to redeem. By this means, they aimed to focus call decisions on relative financing costs.

The Australian Prudential Regulation Authority (APRA) recently wrote to Australian banks and insurance companies to remind them of its regulatory stance on this: A call is an option and not an obligation of the issuer.

APRA's communication states that the issuers of certain instruments should not generally exercise a call on one of these instruments if they would be replacing it with an instrument that is more expensive. APRA also stated that it may make an exception where the issuer satisfies APRA that a particular call:

• Has an appropriate economic and prudential rationale; and
• Will not create an expectation among investors that the issuer will call its other instruments, in similar circumstances.

In our view, APRA's regulatory stance is consistent with existing prudential standards, as well as our assessment that these hybrids are equity-like in nature.

The Era Of Cheap Hybrid Financing Is Over, For Now

In future, we expect hybrid investors to price in a more explicit sectoral risk of a noncall, as they do for some bank hybrids. Of the individual issuers that choose not to call hybrids, some may find their future hybrid issuances see a more targeted pricing premium. We've seen similar primary market pricing effects during past market downturns.

That said, investors generally start to accept lower coupons when credit conditions improve and they start to chase yield again. Market pricing could also stabilize as the role of economic considerations in driving issuer decisions becomes clearer.

Related Criteria

• Hybrid Capital: Methodology And Assumptions, March 2, 2022
• Corporate Methodology: Ratios And Adjustments, April 1, 2019

Related Research

• Australian Regulator's Reminder On Hybrids Should Be No Surprise, Nov. 9, 2022
• Credit FAQ: How We Look At Corporate Hybrid Call And Replacement Decisions, June 8, 2022
• Guidance: Hybrid Capital: Methodology And Assumptions, July 1, 2019
• Guidance: Corporate Methodology: Ratios And Adjustments, April 1, 2019