Last week there was a rare occurrence in the high yield market as German airline Lufthansa announced it would be deferring the coupon on a hybrid bond issued in 2015.
Hybrid debt is so named as it combines features of both debt and equity securities; these bonds are deeply subordinated, they are perpetual, they have coupons that are fully discretionary, and companies receive equity credit (usually 50%) from rating agencies after the issue, thereby offering one attractive option for corporates looking to raise capital.
The yield premium this subordination produces reflects the customary two-notch rating differential between a company’s hybrid bonds and its senior unsecured debt, though this differential can widen in times of stress. Today S&P downgraded the aforementioned Lufthansa hybrid to CC from CCC+, and said it would cut the rating to D if the company skips its February 2022 coupon too (Lufthansa’s senior unsecured rating remains at BB-).
While a deferred coupon would typically imply default, the reasons behind the deferral are idiosyncratic and technical, as Lufthansa was forced to defer by the EU Commission based on its view that such payments “constituted a violation of the state aid regulations of the Temporary Framework for state aid”. This is because Germany’s Economic Stabilisation Fund (ESF) has made silent participations of up to €5.7bn in the assets of Lufthansa, in addition to subscribing to shares by way of a capital increase equating to a 20% stake in the company. In total the package provides stabilisation measures and loans of up to €9bn.
Importantly, most hybrid bonds are described as cumulative within their covenants, so Lufthansa was quick to highlight that it intends to pay back the deferred coupons as soon as possible once the stabilisation by the ESF has been completed (i.e once Germany sells its stake). The reaction in the bonds was initially sharp, falling eight cents on the euro to below a cash price of 90, but they recovered quickly (they were 96 bid on May 20, a day after the announcement) as investors took comfort from Lufthansa’s insistence that their coupons would be made whole. Realistically, selling a 20% stake might take a while for the ESF to complete (the second largest holder recently sold a slice of his holdings), so the bonds have drifted lower in recent days as the market adjusts to what could potentially be a few years without coupons being paid.
Due to the technical nature of the deferral the rest of the hybrid market barely reacted to the news (Lufthansa was the only hybrid issuer to have received what the EU commission defines as state aid), pointing to the historically low risk of coupon deferral in the sector.
However, aside from the customary do-your-credit-work-before-you-invest warning, we think there are a couple of additional lessons from this story. First, as we have previously mentioned, companies that have received state aid to help them through the COVID-19 disruption are likely to face regulatory measures in the future to promote better financial stability, and we expect this to surface in a range of different ways. Second, this is another reminder for investors that all bonds, whether they are Contingent Convertible (CoCo) bonds or not, can essentially be described as having a ‘CoCo’ feature given they can be written down or converted into equity at any time if a company runs into some form of difficulty (or in this case have their coupons suspended while a company repairs its balance sheet).
Luckily for Lufthansa, it arguably got away with the least painful measure and bondholders should live to fight another day.