When BP (BP.) recently told the market it will soon book up to $17.5bn (£14.1bn) in non-cash impairments, investor reaction centred on the growing likelihood of dividend cuts and stranded assets.
Of equal concern is the strain the write-down will place on gearing – which the oil major defines as net debt divided by net debt plus total equity – and which analysts calculated would rise to 41 per cent, or 45 per cent including lease liabilities. That’s well above a target range of 20 to 30 per cent, and approaching a level which raises serious questions for the group’s credit rating.
But when BP releases its interim accounts on 4 August, shareholders will likely find gearing levels well below 41 per cent. This is because immediately after flagging the accounting cuts to its asset base, the group raised $12bn-worth of cash from the sale of several hybrid bond issuances.
There are several things BP investors should know about these securities, which are denominated in a mixture of US dollars, euros and sterling. The first is that they are not classed by auditors as debt, meaning the effect on the balance sheet will be to increase both cash and total equity by $12bn, thereby decreasing the numerator in the gearing calculation (see table).
|Balance sheet line ($bn)||Q1 2020||Impairment ($bn)||Hybrid bond sale ($bn)||HY 2020 ($bn, pro-forma)|
|Source: BP, Investors Chronicle, assumes BP is FCF neutral in Q2|
Second, because the bonds are non-callable perpetual securities, there is no looming maturity date by which BP will need to repay the principal or re-finance. This means the bonds are like preference shares, though BP has retained the right to either defer interest payments (should it need to) or buy back the securities in five or 10 years’ time (should it be able to).
But while there is no impact on gross borrowings, the issuance will lead to an increase in annual coupon payments of around $500m. That’s not exactly pocket change, even for a corporate giant, and presents a large new claim on cash flows that further deprioritises the payment of ordinary dividends.
What’s more, the fact that one $2.5bn tranche comes with a 4.875 per cent coupon is a clear sign that BP’s cost of borrowing is rising. For all the notes’ flexibility, this is a relatively high interest rate for a company with one of the best credit ratings in the world, and while the 10-year US Treasury yields just 0.7 per cent.
Whether the issuance – the largest in debt capital markets to date – will spark an increase in other large companies’ appetite for hybrid bonds is debatable, though fellow European oil majors Repsol and Total have both raised cash this way in recent months.
“I can't predict the future, but a hybrid issuance is always a little bit special, requiring particular circumstances,” says Sven Reinke, senior vice president in the corporate finance group of ratings agency Moody’s. Unlike auditors, ratings agencies value hybrid bonds as a mixture of debt and equity. In rating the bonds ‘BBB’ – its second lowest investment-grade rating – S&P Global argues investors should treat half of the hybrids’ related payments “as equivalent to a common dividend”.
“Usually you need to be a strong creditor to issue hybrid bonds, which is one of the reasons why it isn’t so common,” adds Mr Reinke. “But it is also a reflection that BP is facing very difficult times, as these securities are expensive compared to senior unsecured debt.”