Fitch reduces allocation categories for hybrids, ditches equity cap

By Susanna Moon

Chicago, July 11 - Fitch Ratings said it tweaked the criteria for treatment of hybrid securities in the corporate and real estate investment trust sectors. Credit ratings should be unaffected by the changes, according to an agency press release.

Under the revised criteria, debt and equity allocation will be simplified into three categories - 100% equity, 50% equity and 50% debt, and 100% debt - from five categories.

Also, there will be no explicit limit on the amount of adjusted equity that can be derived from hybrids. Before the change, there was a cap of 30% of total equity and equity from hybrids.

As before, interest expense and dividends of hybrids are not adjusted.

A focus on preserving viability will be more strictly applied in the new criteria, the release said. The terms should avoid mandatory payments, the ability to incur covenant defaults or events of default that could trigger a general corporate default or liquidity need. Structural features that constrain a company's ability to activate the equity-like features of a hybrid make an instrument more debt-like and eliminate equity treatment.

Fitch said the new guidelines follow its exposure draft of Feb. 10, with the difference being that cumulative corporate preferred and preference shares will be allocated 50% to debt and 50% to equity, while only those with a non-cumulative deferral option will be eligible for the 100% equity category.

The draft also indicated that both cumulative and non-cumulative preferreds would receive 100% equity treatment.

In the REIT sector, no distinction is made between cumulative and non-cumulative preferred capital. Both are assigned to the 50% debt, 50% equity category to calculate risk-adjusted capital ratios and to the 100% equity category to calculate financial leverage ratios, the release noted.

Fitch expects limited fallout

Fitch said it reviewed the potential impact of altering its allocation of hybrid securities into equity and debt components across its ratings universe in the emerging markets, Asia and North America corporate and U.S. REIT portfolios.

Some of the findings after publishing the draft in the first quarter are as follows:

• Corporate leverage ratios of adjusted debt to EBITDA would change only slightly if the proposed guidelines were applied. For corporate issuers, the change ranged from plus 0.1 times to plus 0.3 times, and the largest impact for any corporate issuer amounted to an increase in leverage of only plus 0.5 times;

• REITs are expected to show slightly weaker risk-adjusted capital ratios as a result of the change, but no change is expected in financial leverage ratios; and

• Overall, no ratings changes are expected in the corporate and REIT sectors due to the implementation of new guidelines governing hybrid equity.

This report and two related reports covering bank hybrids and hybrids issued in the insurance sector replace "Equity Credit for Hybrids & Other Capital Securities - Amended" dated Dec. 29, 2009, which has been withdrawn, according to the release.

The new criteria reports do not address or change how Fitch rates hybrid securities, the agency noted.

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