Analysing complex capital structures – perpetual bonds

Many companies look beyond straight debt and ordinary shares when raising finance, with capital structures increasingly including an array of complex financial instruments. This presents challenges for investors, particularly when analysing performance and leverage.

We investigate the effects of one form of ‘hybrid’ financing – perpetual super-subordinated bonds – where securities with debt-like features may be reported as equity in financial statements. Recent proposals by the IASB to improve transparency in reporting these instruments and other complex capital structures will help investors.


The capital structure of many companies includes complex financial instruments, for example derivatives on common shares such as written or purchased puts and calls, convertibles, and bonds or preference shares with features of both debt and equity. It is not easy to faithfully represent these instruments in financial statements where claims must either be reported as debt or equity – there is no ‘mezzanine’ or ‘hybrid’ finance category.

However, the complexity can be dealt with in other ways, such as the bifurcation that is applied to convertibles (at least under IFRS1Under IFRS most convertibles are bifurcated into a straight bond plus an embedded call option. Under US GAAP the use of bifurcation is much more restricted, which we think results in an overstatement of profit. For more about this see our article ‘Convertible accounting: New US GAAP inflates earnings’.), the calculations associated with basic and diluted earnings per share, and various required disclosures. But despite these, it can still be difficult for investors to assess the impact of different forms of financing on performance metrics, and the risk and return of their own investment in the business. It is for this reason we welcome recent proposals by the IASB to enhance the transparency of complex capital structures.

We address the IASB exposure draft later. Firstly, an illustration of the challenges for investors arising from one form of hybrid financing.

Perpetual super-subordinated bonds

As the name suggests, perpetual super-subordinated bonds do not have a fixed repayment date, although the issuer may have an option to redeem the bonds on certain specified dates. The bonds are subordinated to all or most other debt and therefore rank after these in the case of a liquidation. Furthermore, interest payments may be deferred at the discretion of management without the non-payment being an act of default, as would be the case for regular debt – hence the name super-subordinated.

Of course, no investor would ever purchase a bond where interest payments can be deferred indefinitely just because management chose to do so (and with no adverse consequences), and where the principal never has to be repaid. To sell these bonds to investors, issuers need to include some features or incentives to ensure that investors do actually expect to receive both interest and eventual repayment of the principal.

The precise terms of these instruments obviously vary but common economic incentives include:

  • Interest payments: Bond interest payments may be linked to the payment of dividends to common shareholders. If the issuer elects to not pay interest on the super-subordinated bonds, the company is not permitted to pay dividends to its ordinary shareholders. Any missed interest must be paid before ordinary dividends can be resumed. This restriction on payment of ordinary dividends gives a strong incentive to pay the bond coupon.
  • Principal repayment: To incentivise the repayment of bond principal, interest payments after a specified date may increase by a pre-determined amount. Only by calling the bond (using the option to redeem on specified dates) can the higher interest expense be avoided. Securities with increasing interest amounts are sometimes called stepped bonds.

These incentives to pay interest and principal included in bond terms are often referred to as creating an ‘economic compulsion’ on the part of the issuer. Although there is no contractual requirement to pay interest or repay the bond principal, the damaging negative economic effects of not doing so provide a strong economic incentive (compulsion) to make the payments.

Here is an extract from a series of disclosures about several perpetual super-subordinated bonds issued by airline AirFrance-KLM.

“… From the issue date until November 23, 2025, the bonds bear interest at a nominal rate of 6.5% per annum, payable quarterly in arrears. From November 23, 2025, the bonds will bear interest at a rate equal to 1,300 basis points above the applicable 3-year Euro Mid-Swap rate as reference rate, subject to review every three years thereafter. Interest is payable quarterly in arrears. The bonds are for an indefinite period, and the Air France- KLM group may, at its option, redeem all the bonds early … “

AirFrance-KLM 2023 financial statements

Notice the increase in interest rate from 6.5% to 13% above the 3-year swap rate (at present a total rate of about 15.9%). Clearly there is a strong economic incentive to redeem the bond on or before the date in 2025 when this interest rate increase takes effect. What looks like long-term financing is highly likely to be repaid or refinanced much earlier.

Perpetual bonds may have characteristics of both debt and equity

The result is that perpetual super-subordinated bonds have characteristics of both debt and equity. They are equity-like in the sense that, like ordinary shares, there is no contractual obligation to ever pay interest or repay principal. On the other hand, they are debt-like in the sense that the interest is like a regular bond coupon which does not vary depending on the performance of the business, and a fixed amount is payable on redemption.

The more compelling the ‘economic compulsion’ to repay interest and principal, the more debt-like the security appears. Indeed, most of these securities trade alongside other regular debt instruments in the capital markets, albeit with a higher yield because of their super-subordinated status.

AirFrance-KLM has a total of 6 super-subordinated bonds included in its 2023 financial statements.

AirFrance-KLM perpetual bonds classified as equity

AirFrance-KLM 2023 financial statements

The aggregate carrying value of these perpetual bonds is €3,600m, which is a significant component of this company’s overall capital structure. How these instruments are presented in the AirFrance-KLM balance sheet, and the accounting applied to the bond coupon payments when measuring performance, matters a lot when analysing this company.

Accounting for perpetual super-subordinated bonds

All instruments issued by a company must either be reported as a financial liability (in other words debt) or as equity in financial statements. In IFRS, the definition of a financial liability is given in IAS 32. The relevant part of the definition2There is a bit more to the definition – for example, financial liabilities also include contracts settled by delivering a variable number of own equity shares where there is no commitment to pay cash or transfer another asset. that matters in classifying perpetual super-subordinated bonds is:

“A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another entity … “

IAS 32 para. 11

The key phrase is “contractual obligation to deliver cash”. All the AirFrance-KLM bonds listed in the note above are classified as equity because the ‘economic compulsion’ type incentives described above do not create a contractual obligation to make interest or principal payments. The existence of terms that may make interest payments likely, such as the interest rate increase we highlight, are irrelevant to the classification if there is no contractual requirement to make those payments.

Equity classification does not apply to all perpetual bonds. If management does not have the right to defer payment indefinitely then the full amount of the bond would be classified as debt. Indeed, AirFrance-KLM has other perpetual subordinated bonds that are classified as debt.

Equity classification and tax-deductible interest can make this an attractive form of financing

The consequence of equity classification is that no interest expense is reported in the income statement, with the payments to the holders of perpetual bonds regarded as a distribution of profit. In the balance sheet the capital raised is included as part of shareholders’ equity. Higher profit and lower (apparent) leverage provide an advantageous presentation. In addition, these instruments are normally regarded as debt for tax purposes and therefore interest payments are tax deductible. This ‘best of both worlds’ position makes issuing these types of securities attractive, despite the likely higher interest rate demanded by investors.

The classification as equity or debt matters for investors because of the resulting impact on performance metrics and leverage ratios. If your approach to analysis and valuation is based on enterprise value, the profit impact is arguably less important, considering that operating profit is unaffected. However, the nature of the claim is still relevant in assessing leverage and, for example, cost of capital. But if your focus is on earnings and price earnings ratios then understanding the accounting and how the interest expense is reported is extremely important.

Of course, the accounting does not change the underlying economics and investors should be able to look through the financial statements to assess leverage and profitability. However, classification of a security as equity, when most investors would regard them as economically closer to debt, does create analytical challenges.

We explain the accounting using relevant extracts from the financial statements of AirFrance-KLM:

AirFrance KLM accounting for perpetual super-subordinated bonds

Balance sheet extract – equity capital

Income statement extract – earnings and its attribution

……..

AirFrance-KLM 2023 financial statements

In the balance sheet the AirFrance-KLM perpetual bonds are presented as a separate component of equity. Those issued by the parent company are included in parent shareholders’ equity, whereas those issued by a subsidiary are a component of non-controlling interests – €1,076m and €2,524m respectively for 2023 in the extract above.

We note that AirFrance-KLM does not include super-subordinated bonds in its definition of net debt. The 2023 net debt is given as €5,041m, whereas the aggregate carrying value for the perpetual bonds classified as equity is €3,600m. While these bonds do have economic characteristics that differ from the claims classified as debt, they are sufficiently debt-like to warrant careful consideration when analysing leverage.

Perpetual bond interest is not an expense and is not separately presented as an ‘attribution’

In the AirFrance-KLM income statement there is no mention of the perpetual bond interest. Due to the equity classification of these bonds, the interest payments are not included in profit and loss as an expense. Instead, the distributions to bond holders are part of the analysis of net income into the amounts attributable to NCI and to the parent company equity investors.

Of the €56m reported as the earnings attributable to NCI, €53m represents the interest ‘expense’ on perpetual bonds. The coupons related to perpetual bonds issued by the parent are paid from the group part of net income. However, none of these interest payment distributions are disaggregated on the face of the income statement. Only by analysing either the statement of changes in equity or the earnings per share footnote can they be identified.

AirFrance-KLM perpetual bonds – disclosures provided in the footnotes

Statement of changes in equity extract – perpetual bond flows

……..

Earnings per share note extract

AirFrance-KLM 2023 financial statements

Note: We have no criticism of the accounting by AirFrance-KLM which we believe fully complies with the current requirements of IFRS. Their disclosures are both comprehensive and informative.

The above statement of changes in equity shows the movements in the perpetual bonds during the year, including new issues (less redemptions) and interest payments (coupons). For example, the interest accruing in 2023 for those perpetual bonds issued by the parent company is €72m. Interest paid in the year is €62m, with the accrued unpaid amount of €10m reported as an adjustment to the equity amount for the perpetuals. Unlike interest on a bond classified as a liability, the accrued interest is not itself a liability. The related tax savings are also reported as a movement in equity.

Reporting interest as a distribution not an expense makes the analysis of performance challenging

The main problem for investors is understanding performance when interest payments are reported as a distribution of earnings rather than as an expense. Only in the calculation of earnings per share is the distribution to holders of perpetual super-subordinated bonds directly included in a performance metric. EPS represents earnings attributable to only common shareholders, whereas earnings reported in the income statement is the return to all providers of equity capital.

Although information is available to adjust profit and leverage metrics to include the effects of bonds classified as equity, doing so in practice may not be a trivial exercise.

No proposal to disclose the fair value of bonds or derivatives classified as equity

A further problem faced by investors when debt-like securities are classified as equity is that the required disclosures for equity instruments are significantly less detailed than they are for debt. For example, there is no disclosure of the fair value of equity instruments, including the above super-subordinated bonds and, perhaps more importantly, equity derivatives3We have previously called for disclosure of the fair value of derivatives classified as equity, including employee stock-options, in several of our articles. See for example ‘Enterprise to equity bridge – more fair value required’.. Fair value disclosures are provided for all financial liabilities. In addition, the IFRS liquidity disclosures do not apply to equity even though interest and principal payments may be highly likely. Unfortunately, neither of these issues are addressed by the IASB in their recent exposure draft.

Here is our summary of the accounting:

Debt versus equity classification for perpetual super-subordinated bonds

Remember that classification in financial reporting is binary, but that the economic nature of these instruments can vary depending on the terms of the security. Many will be both debt-like and equity-like to varying degrees.

IASB proposals to improve transparency

The accounting for perpetual bonds classified as equity has long been controversial. Some argue that these instruments would be better reported as debt, and that the definition of a liability should be changed to achieve this.

No change to classification but more clarity regarding attribution and debt-like features

The IASB has adopted a different approach that seeks to add transparency through changes to presentation and disclosures about perpetual bonds and other non-common share instruments classified as equity. We focus on just one aspect of the Exposure Draft – the proposals for the ‘attribution’ of equity and profit between common shareholders and other equity investors. If you are interested in reading about the other proposed changes, see the IASB’s own ‘snapshot summary’. We support the objective of the IASB and most of the specific proposals; the main area where we disagree is the accounting for written put options.

Proposed greater disaggregation of equity capital and net income attributable to different types of equity

To enhance the understanding by investors of the financial effects of perpetual bonds and other non-common share instruments classified as equity, the IASB is proposing to extend the presentation of ‘attribution’. In the balance sheet total parent shareholders’ equity would be disaggregated into that attributable to common shares and that attributable to other equity instruments. In the income statement total earnings (net profit) would be similarly split into that attributable to common shareholders and other equity. In both cases this is in addition to the existing analysis of total equity between parent shareholders and non-controlling interests.

In our view this change would be helpful for investors. In fact, we think that the proposals could go further, with the non-common share equity disaggregated by type of instrument if their economic characteristics differ, with non-controlling interests similarly disaggregated.

AirFrance-KLM are already close to this proposed balance sheet format, considering their separate presentation of the perpetual bonds, although the IASB proposes a new subtotal for parent equity attributable to common shares. However, it is in the income statement that this company and many others would see a more significant change. At present there is no indication that any of the earnings attributable to parent shareholders (or indeed NCI) is, in effect, an interest expense for perpetual bonds. The IASB proposes that this ‘distribution’ be shown separately.

This is what AirFrance-KLM might look like under the IASB proposals (with our own additional disaggregation and reformatting):

Alternative presentation for the attribution of AirFrance-KLM earnings

AirFrance-KLM 2023 financial statements and The Footnotes Analyst assumptions and estimates

(1) The other dividend is a payment to the French state that the company considered to be a distribution, and therefore recognised directly in equity, but taken into consideration in determining EPS. We therefore regarded it as an attribution to non-common share equity in our above calculation.

(2) In our view, tax related to attributions to non-common share equity should be included in the above reconciliation. However, we have not included the tax credit related to perpetual bond interest that is disclosed in the statement of changes in equity because the company has not included this in its own calculation of EPS.

Both net income and the amount attributable to parent common shares (the amount used for EPS) are unchanged in our expanded presentation of attribution. However, we think the presentation of all attribution on the face of the income statement, and the additional disaggregation, gives investors better insight into the effects of this complex capital structure.

Tell us what you think

We believe the changes proposed by the IASB regarding attribution, including the separate presentation in the income statement of interest on perpetual super-subordinated bonds classified as equity, would make the reporting more transparent. Alternatively, some of you may argue that the existing accounting is just fine and there is no need for additional disclosures. Or you may think that these instruments are, in substance, debt and that the definitions of debt and equity used in financial reporting should be changed.

Tell us what you think by selecting one of the options below. Submit your vote to see the result of our poll so far.

Or if you have a different view, use the ‘questions and comments’ link below.

Insights for investors

  • Financing is only classified as debt if there is a contractual obligation to make interest or principal payments. Contractual terms that only create an ‘economic compulsion’ to pay are irrelevant.
  • Some forms of financing that are classified as equity, including perpetual super-subordinated bonds, may in substance be closer to debt and contribute to higher financial leverage.
  • Financing expense for debt-like instruments classified as equity is not reported in the income statement as an expense, although it is deducted in EPS calculations. The amounts are likely to only be disclosed in the statement of changes in equity and in the earnings per share note.
  • The amounts reported as NCI in the balance sheet, and as an attribution of earnings in the income statement, may include amounts arising from debt-like instruments issued by subsidiaries.

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