OREANDA-NEWS. An innovative hybrid issuance by UK supermarket operator J Sainsbury has generated significant interest from investors and advisers, suggesting it could be the first of a new generation of hybrid securities in Europe, Fitch Ratings says.

Sainsbury's bond, issued at the end of July, is unusual because it gives the bondholder an option over five years to convert into equity at a material premium to the share price on the day of issuance. Until now, European hybrid issuance has generally been based on a few standard template structures. Other features of the Sainsbury's issue are similar to these standard structures, including giving management the ability to cumulatively defer coupon payments.

The bond was priced at 2.875%, which is lower than a standard hybrid instrument. This indicates that investors attributed value to the equity conversion option and as a result accepted a lower coupon. Structuring an instrument in this way results in greater financial flexibility than a standard hybrid security due to the lower coupon and because any conversion into equity over the five-year period will provide permanent support to the capital structure.

Fitch attributes 0%, 50% or 100% equity credit to hybrid securities. We do not rate Sainsbury, but we have received numerous inquiries about how we would look at such instruments from a rating perspective. The security would not have attracted any equity credit under our criteria because it includes a high step-up in coupon in July 2020. This creates a clear incentive to repay or refinance the debt and means it cannot be considered a permanent part of the capital structure.

But many Fitch-rated hybrid securities fulfil the minimum structural requirements for 50% equity credit. Including a conversion option in one of these market standard hybrid debt instruments would not improve the equity credit, but it would add some financial flexibility. Investors would probably only see this type of product as attractive for issuers with good equity growth potential. This limits the pool of potential issuers.

Many arrangers have also been looking into structuring hybrid securities that qualify for 100% equity credit. To achieve this under our criteria, coupon payments must be non-cumulative, meaning the holder's rights to the coupon are lost if it is skipped. This type of feature could again be more acceptable to investors if they are confident in the issuer's equity potential, but there has been no precedent transaction. To date, hybrid instruments with 100% equity credit have been very rare.