# Analysis of Terna S.p.A.'s Hybrid Bond Utilization

## 1. Current Hybrid Bond Position

Terna already issued €989 million in perpetual hybrid bonds during FY2022, as evidenced by the equity statement line "Equity Instruments Perpetual Hybrid Bonds" showing €989 million added during the period, with coupon payments of €21.1 million charged to retained earnings.

## 2. Capital Structure Assessment

**Total Equity (end FY2022):** €6,169.1 million (including €989 million hybrid bonds classified as equity)

**Total Debt:**
- Long-term borrowings: €8,416.7 million
- Short-term borrowings: €444.1 million
- Current portion of long-term borrowings: €1,909.3 million
- Total gross debt: ~€10,770.1 million

**Total Adjusted Capital (Equity + Adjusted Debt):** Approximately €16,939 million (rough estimate, adjusting for the hybrid's 50% equity/50% debt treatment under S&P methodology).

**Current hybrid as % of total adjusted capital:** €989 million / ~€16,939 million ≈ 5.8%

This means Terna is already utilizing hybrid instruments but is below the 15% S&P cap.

## 3. Business Risk Profile

Terna is Italy's electricity transmission system operator (TSO) — a **regulated utility** operating as a natural monopoly under Italian/EU regulatory frameworks. Key characteristics:

- **Regulatory advantage:** Italy's regulatory framework (ARERA) is well-established, transparent, and provides for cost recovery and return on invested capital. This would typically be assessed as strong/adequate to adequate.
- **Scale, scope, and diversity:** Terna is the sole national TSO in Italy — very large scale but single-jurisdiction concentration. Revenue is predominantly regulated (~59% from related party transactions with regulated counterparties).
- **Operating efficiency:** EBITDA margin is robust. Operating profit of €1,333.5 million on revenue of €2,964.5 million suggests an EBITDA margin around 69% (adding back D&A of €725.7 million gives EBITDA of ~€2,059 million).
- **Profitability:** Strong and improving — net income grew from €790.8 million to €857.7 million (+8.5%).

## 4. Financial Risk Profile

**Leverage metrics:**
- FFO/Debt: EBITDA ~€2,059 million, interest ~€122 million, taxes ~€355 million → FFO ≈ €1,582 million. FFO/Debt ≈ 1,582/10,770 ≈ 14.7%
- Debt/EBITDA: ~10,770/2,059 ≈ 5.2x

These metrics suggest moderate-to-significant leverage for a regulated utility. For a low-volatility regulated utility, S&P would typically require FFO/Debt of 13%+ for BBB, suggesting Terna is near the lower end of investment grade.

**Capex intensity:** Capital expenditure is significant and growing:
- PP&E purchases: €1,492.3 million (up from €1,344.2 million)
- Intangible asset purchases: €212.4 million (up from €130.8 million)
- Total capex: ~€1,705 million, representing very high capital intensity relative to operating cash flows

**Free cash flow:** Operating cash flow of €2,323.7 million minus investing activities of €1,855.4 million = positive but thin free cash flow margin. With dividends of ~€596 million, discretionary cash flow is limited.

## 5. Interest Rate Environment

The swap curve shows a dramatic shift from negative rates to significantly positive rates in 2022 (5Y: from -0.264% to 1.726%; 10Y: from 0.053% to 1.927%). This means:

- Refinancing costs have risen substantially
- The spread differential between senior and subordinated debt (delta ~0.2% based on iBoxx data) is relatively modest
- The hybrid coupon cost (implied ~2.1% based on €21.1 million coupon on €989 million) was issued in a favorable rate window
- New hybrid issuance would be more expensive given the rate environment

## 6. Refinancing Needs

- Current portion of long-term borrowings: €1,909.3 million (significant near-term maturities)
- Short-term borrowings: €444.1 million
- Total near-term refinancing: ~€2,353 million

This indicates substantial refinancing needs.

## 7. Rating and Leverage Considerations

Terna's leverage is moderate-to-high for a regulated utility. The company has:
- Growing capex needs (energy transition, grid reinforcement)
- Significant near-term debt maturities
- Already issued hybrid bonds, indicating management recognizes the need for capital structure optimization
- Moderate dividend payout reducing retained earnings available for deleveraging

The existing €989 million hybrid represents approximately 5.8% of total adjusted capital. There is room within the 15% cap for additional issuance.

## 8. Assessment Against Guidelines

**Arguments for maintaining current level (~7.5%):**
- Terna already has hybrids in its capital structure (~5.8% of TAC)
- The rising interest rate environment makes new hybrid issuance more expensive
- The company has strong regulated cash flows providing reasonable organic deleveraging capacity
- Rating pressure exists but is manageable

**Arguments for increasing to 11.25%:**
- High capex intensity with growing investment needs for energy transition
- Leverage is at the tighter end for investment grade
- Refinancing needs are substantial
- Additional hybrid issuance could provide meaningful rating protection

Given that Terna:
1. Already has ~5.8% hybrid utilization
2. Has high and growing capex needs
3. Has moderate leverage pressure for its rating category
4. Faces significant refinancing needs
5. Operates in a higher interest rate environment (making additional hybrid more costly but still rational for rating protection)
6. Has a strong regulated business profile that supports hybrid issuance

The company should moderately increase hybrid utilization. The current level is close to 7.5%, and given the ongoing capex pressure and refinancing needs, maintaining or slightly increasing the hybrid portion makes sense. However, the cost differential in the current rate environment and the already-existing hybrid argue against pushing to the maximum.

The optimal recommendation is **7.5%** of total adjusted capital — essentially maintaining the current hybrid strategy with modest additional capacity, reflecting the balance between leverage optimization needs and the increased cost of new hybrid issuance.

<answer>7.5%</answer>