Judgement call - Some securities would appear to be blurring the line between debt and equity


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

Over recent months, in articles such as Flashing lite, The Value Perspective has been cataloguing the increase in issuance of exotic-sounding debt instruments. To a list that has so far included the likes of PIK Toggle bonds, collateralised loan obligations and covenant-lite loans, we can now add ‘undated deeply subordinated non-call securities’.

Nearly $1.8bn (£1.1bn) of these were issued in March by Telefonica, the Spanish telecoms giant that owns O2 in the UK, at interest rates of 5% to 6% and with tenures ranging from six to 10 years. We believe these instruments should be thought of as debt rather than equity because interest is paid on them and, above all, their holders rank ahead of ordinary equity investors in the corporate structure.

For accounting purposes, however, they are often treated, at least partially, as equity and that offers a clue as to why Telefonica may have taken this route to raising further capital. First, the company already has a lot of debt and obtaining more is likely to be proving tricky so this ‘equity’ path has its attractions.

Second, it helps improve the appearance of Telefonica’s net debt position – which is the company’s total debt burden minus its cash balances. Investors often look at ratios that make use of this measure as a guide to the strength of a company’s financial position.

Usually when a company takes on debt, the upside is it brings cash in the door but the downside is that the debt now sits as a liability on its balance sheet, so overall its net debt has not changed. If some or all of this debt is counted as equity, however, the company enjoys a double benefit. Not only does the cash still come through the door, it is not all viewed as debt – thereby reducing the company’s net debt and boosting the appearance of its financial stability.

If you look at it more closely, even the name ‘undated deeply subordinated non-call securities’ starts to sound a lot like equity. After all, equities are supposed to be long-term capital that is deeply subordinated – in other words, ranking at the bottom of the pile. It is also not ‘callable’ – once you have bought it, you are stuck with it unless you can sell it on to someone else.

Is Telefonica looking to take on more debt without really characterising it as such? And, if so, might this be a signal the company could be starting to worry it has too much debt? All we would say is that, if we include the undated deeply subordinated non-call securities in our calculations, Telefonica’s net debt to EBITDA ratio is nearly 3x, which is certainly above the level where we would worry.


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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