This request for comment discusses the credit risk of preferred stock and so-called hybrid securities and suggests guidelines for rating these securities in light of their unique features.
We propose to combine existing notching guidelines, which address severity of loss in the event of default, with incremental notching to reflect the fact that scheduled payments may be omitted without triggering a default by the issuer.
Hybrid securities – combining features of both debt and equity – have become an increasingly visible financing source for corporate and financial institution issuers around the world. Regulated entities, in particular, find hybrids to be a tax-efficient way to raise capital. Hybrid securities can take the form of preferred stock, subordinated debt, convertible bonds, or securities with mandatory conversion to equity.
Moreover, like their preferred stock counterparts, many hybrid securities contain special clauses which allow an issuer to omit payments, either at the issuer’s option or because a pre-set “trigger” has been breached. While perhaps offering benefits to the issuer’s overall credit profile these features can pose an additional risk for investors holding these securities. By factoring in this additional risk, Moody’s rating for these securities would extend beyond the explicit promise of the contract. In essence, the ratings would reflect an expectation that payments would in fact not be omitted.
Specifically, we are proposing a two-step process for rating preferred stock and hybrid securities. The first step is to derive a loss-given-default (LGD) rating for the security, based on the issuing entity’s rating and the security’s position in the issuing firm’s capital structure. The second step is to assess the risk that payments would be omitted, without triggering a default, and incorporate this into the hybrid security’s rating. Moreover, we are proposing to extend this process to conventional non-cumulative preferred securities.
