Preferred/Hybrid Issuance Jumps in Midstream Sector
Junior subordinated hybrid debt and perpetual preferred stock issuance jumped meaningfully for midstream issuers in the second half of 2017, as this week’s chart demonstrates. The midstream sector, dominated by master limited partnership (MLP) structures, commonly generates significant amounts of negative free cash flow, as the majority of operating cash flows are distributed to shareholders and capital spending is funded externally. While issuers have reigned in capital expenditure (capex), sold non-core assets, or cut distributions to alleviate some stress on cash flow, the sector continues to rely on external capital.
Issuers have shown preference for accessing this capital in the form of hybrids or perpetual preferreds as MLP equities have been poor performers. As you can also see in this week’s chart, the S&P MLP Index (SPMLP) finished 2017 with a negative 12% return, a significant underperformer relative to the broader market (S&P 500 Index up approximately 21%). As a result, raising capital in the equity market is very unattractive. Raising debt is also not a desirable alternative with sector leverage already at elevated levels.
Junior subordinated hybrid and perpetual preferred structures receive partial equity treatment from rating agencies, making them a much more cost efficient option. Depending on the particular issues, the rating agencies generally give more equity treatment for structures that are deemed as a more permanent source of capital. Those that are perpetual, have very long dated final maturities, or have coupon steps that are not exorbitant to incentivize an early redemption are considered more equity-like. For investment grade issuers of senior unsecured paper, hybrids or preferred issuance from these entities will generally be attributed 25% to 50% equity treatment by the rating agencies. Therefore, as long as yields remain low and investor demand remains, along with an unattractive equity option, hybrid and preferred issuance will continue.
S&P hasn’t committed to a hard limit on the amounts of hybrids a company can issue that will be assigned equity credit. However, they indicated that 15% of capitalization seems to be a reasonable threshold, as beyond a certain point a “company’s nonstandard, complex, or over-engineered balance sheet begins to put its financial policies in a negative light.” Moody’s caps issuance at 30% of total equity.
At the end of 2017, the hybrid and preferred midstream space had experienced pricing pressure as investors braced for more supply from issuers to address capital needs and some large M&A-driven deals. While the potential additional supply may weigh on performance in the short term, these instruments in select credits offer compelling long-term value in a continued low interest rate environment. From a bondholder perspective, hybrid structures with high back-end coupon steps and/or non-perpetual can be attractive holdings given the spread pick-up relative to senior unsecured paper.
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