Posted Date : 18 Apr 2014

MARC published its final methodology on equity treatment and notching for corporate subordinated debt and hybrid securities today following a request for comments period. The methodology report outlines concepts and principles that are applicable to assigning ratings to all types of subordinated and hybrid securities issued by corporates. 

The report incorporates market feedback MARC received after publishing its exposure draft on the same subject on February 25, 2014. For confidentiality reasons, the comments are presented in aggregate with the amendments that have been implemented. MARC gratefully acknowledges the participation from the respondents, principally debt capital market professionals.
Based on the feedback received as non-written submissions, MARC has implemented changes to the methodology and provided clarification to respondents’ comments as follows:
  • MARC’s final methodology now considers perpetual resettable step-up subordinated securities that are callable after five years for immediate or 50% equity content provided that the terms of the coupon reset and the step-up in coupon do not, in the rating agency’s view, give the issuer incentive to call the bonds at the first opportunity. This will address scenarios where the coupon resets in the fifth year but only steps up in year 10, or steps up by a small margin if the call is not exercised. 
  • Generally, MARC regards coupon step-ups over 100 basis points as onerous and is of the view that the interest rate scenario is pertinent to the issuer’s incentive to call the bond at the call dates. A downward trend in interest rates makes the issuer more likely to use the call feature to issue new debt at lower rates. MARC maintains management intent as a key consideration in assessing the permanence of perpetual securities. Replacement provisions will always be analysed in combination with the issuer’s market access. 
  • More clarity has been provided in terms of the treatment of mandatory convertible securities in the final methodology, particularly on the equity-like characteristics that would result in a 75% equity credit being given to a mandatory convertible security as opposed to 100%, as well as the justification for MARC’s view that mandatory deferral features are more credit supportive for an issuer that is facing credit deterioration than optional deferral mechanisms. On a related note, MARC believes that a deferral far ahead of an issuer experiencing financial stress can be triggered if the triggers are set at a level that can easily activate the mandatory deferral features.
  • MARC’s final methodology also identifies the particular features of a mandatory convertible which would detract from the equity credit otherwise implied by its core features, which would result in minimal equity credit being assigned to the security. 
  • On the amortisation of equity credit, MARC clarifies that its focus remains on the security’s effective maturity. This can be the contractual maturity of the security or ‘expected maturity’ where call features, coupon rate resets and step-ups will, in MARC’s view, affect the permanence of the hybrids. In the latter scenario, MARC assesses the likely timing of the redemption/repurchase of the security, taking this to be the effective maturity of the security.
  • On MARC’s notching approach, the rating agency clarifies that while guidance has been provided on the notching of individual issues relative to the issuer’s senior debt rating, the rating that will be finally assigned will reflect the risk carried by the security and its equity content. As a general rule, the notching for initial issue ratings on hybrids and subordinated debt should not exceed the guidance provided. MARC may narrow the notching for hybrids under certain circumstances as indicated in the final methodology.
MARC does not anticipate that the methodology will result in materially different ratings when applied to new or existing corporate subordinated debt and hybrid securities. The rating methodology can be accessed on MARC’s website at  Equity treatment and notching for corporate subordinated debt and hybrid securities.
Milly Leong, +603-2082 2288/ milly@marc.com.my.