The reason is not that this product could blow up when the credit cycle turns, although there are plenty of investors who consider these deals to be a bull market trade.
It’s not a corporate problem either – only $2bn of US corporate deals have been issued to date.
In the US, underwriters and issuers face a more immediate problem – getting investors and regulators to understand the many new hybrid structures that have been launched by financial institutions group (FIG) issuers since last August in the first place. Only $12bn of these new deals – that receive much higher equity treatment from the rating agencies at a debt cost – have been issued, yet already some investors have got burnt and regulators are upset.
In the latest assault on this infant market, a March decision by The National Association of Insurance Commissioners (NAIC) meant the US institutional market was essentially shut for seven weeks, forcing credit spreads on existing issues to widen across the board and making the product’s future uncertain.
The NAIC announced on March 14 that it considered the first of this new generation of hybrids, Lehman Brother’s enhanced capital advantaged preferred securities (Ecaps) issued last August, to be straight equity.
The market was astonished, not least the insurance companies, some of whom had been classifying these as debt. At the very least, shouldn’t this deal be classified as preferred shares like other traditional Tier 1 capital structures?
“The NAIC has thrown a monkey wrench into the process,” says David Hendler, senior US financial services analyst at CreditSights. “The banks are saying the NAIC isn’t playing by the rules, when it seems that the insurance companies are also guilty, because they have been misclassifying these deals to the NAIC as debt.”
Rating agencies are standing firm, saying they expect these deals to behave like investment-grade bonds, not equity. Standard & Poor’s says that, as far as its own risk-based models are concerned, it is still treating the Ecap deal as preferred. But a conference call held in late April gave little insight on the NAIC’s views on Ecaps or how it would view any of the new hybrids issued since.
“You would like them to say, ‘if you do this, it’s preferred, if you do this, it’s common equity’,” says one banker. “There are existing NAIC rules that will tell you that, but apparently in this case they are not applied.”
Slow off the mark
So investment banks are frantically banding together to lobby the NAIC to clear up the issue. Perhaps they should have acted before. “Investment banks could have asked for pre-launch classification for these deals from bodies like the NAIC,” says Mr Hendler. “Maybe they thought they didn’t need to or maybe they didn’t want to give away information about their own proprietary structures. Either way, it looks as though they planned all the closing dinners before they’d launched a single issue.”
When the current stand-off will be resolved, no one really knows. At the time The Banker went to press, Lehman Brothers was set to appeal the decision on Ecaps, and once that is done the NAIC has 90 days to respond. But right now, faced with punitive capital requirements if these deals are classified as equity rather than preferred stock, insurance companies, which are the biggest buyer in the market and on average purchase 20% of these issues, are temporarily locked out.
| “Could the product survive without insurance company participation? Yes it could. Will it thrive? I have questions,” says Jeff Kushner, managing director at credit fund manager Blue Mountain Capital Management. “Ultimately, though, I think it is likely that the NAIC will come to a decision that allows insurers to play in this market.” |
Everyone hopes so as it wasn’t supposed to be like this. When Moody’s and S&P revised the amount of equity credit they would give to new FIG hybrids at the beginning of last year (75% at Moody’s, 100% at S&P), a number of investment banks, including Lehman Brothers, Merrill Lynch and Morgan Stanley, started structuring their own versions of the new hybrids – enhanced trust preferreds and mandatory convertibles – that would still have favourable tax treatment but receive enhanced equity credit from the rating agencies.
Bumper forecast
Analysts began the year predicting between $40bn and $75bn of new US hybrids in 2006, including the refinancing of the $20bn old trust preferred securities in the market (Trups) that could be called this year. Issuers could use them to fund acquisitions or reduce their weighted average cost of capital.
US Bancorp, the most frequent issuer of enhanced trust preferred deals to date, decided it would look at enhanced trust preferred after various banks pitched several versions of the new structure to it last year.
“We were going to refinance our existing trust preferreds that we could call this year, even before the developments in the hybrid capital market,” says the bank’s treasurer, Daryl Bible. “That these allow us to refinance at a better all-in rate and get higher equity credit is a win-win for us.”
In February, Mr Hendler predicted that banks such as Citigroup could boost earnings per share by as much as 8% by issuing hybrids to buy back stock. Investors got excited about picking up yield on high quality issuers and rating agencies and investment banks licked their lips about the fees to structure these complex, bespoke deals – up to 3% of each transaction for the underwriting banks.
It seemed that no one could lose, but by the beginning of this year, there were already uncertainties plaguing the market. When Wachovia’s $2.5bn WITS (Wachovia interest trust securities) transaction was issued in January, there was initial controversy that the Federal Reserve should not have allowed the mandatory convertible to qualify for Tier 1 capital. There was a rush to buy the bond because many investors thought it would be a one-off.
As a result, it was priced at 142 basis points over five-year treasuries, which some analysts said was far too cheap – and did not factor in the extension risk of WITS not being called after conversion.
But then the Fed stood firm on its decision that up to 25% of Tier 1 capital concentrations could be made up from deals like WITS (up from 15% allowed for the old trust preferreds), which some analysts believed could inspire $46bn of copycat deals alone.
There was still some uncertainty about how investors should analyse these deals. After all, since 1994 the only tax-deductible hybrids accepted as Tier 1 capital were Trups. The new generation of hybrids have some similarities, but they also had some distinct new characteristics, including the chance of mandatory coupon payment deferral, as opposed to optional deferral.
Varied products
Furthermore, every deal has been slightly different. As Adriaan Van Der Knaap, head of the strategic solutions group at UBS, explains: “With the advent of trust preferreds in the mid-1990s, each bank had its own product; you would typically go to clients to discuss so many million of trust preferreds, and convince clients why that made sense.
“Now I think there’s much more of a Chinese-menu approach, where clients’ objectives such as rating agency treatment, tax deductibility and regulatory capital needs are determining the optimal structure.”
Having had 10 years to get used to trust preferreds, US investors now have to get to grips with hybrid bespoke transactions. They have essentially got to face the same steep learning curve that European investors did after the overhaul of the European Tier 1 capital market.
Bankers say investors can still make value comparisons between them. “I think the transactions have enough in common to compare them on a relative basis in several key areas: rights in liquidation, rights to distributions, the actual maturity, call features and pricing incentives to call, if any, and the nature of the issuer and whether it is the holding company or the operating company,” says Jill Schildkraut-Katz, global head of issuer product development at Merrill Lynch.
Some investors also believe that they are not such a radical departure. “There are numerous different structures in the Trups market too,” says Kevin Murphy, managing director and high-grade credit team leader in the fixed income group at Putnam Investments.
Deal complications
However, a lot of credit hedge funds and debt-focused money managers who are investing in this product were not involved in the Trups market and are having to quickly get up to speed on their fundamental research. “I think these deals are a lot more complicated than they appear on the surface. They have a lot more moving parts than cash bonds, where it’s mainly about credit risk,” says Mr Kushner. “In particular, people have struggled valuing the extension risk, which is why there’s been some noise in this market.”
That was exactly the problem when Washington Mutual’s $2bn perpetual preferred deal was priced at the end of February. Most new hybrids have some sort of step-up in coupon after a set number of years, protecting investors from extension risk. Investors thought WaMu’s hybrid was no exception. They were wrong. Spreads on the new issue widened 50 basis points immediately as investors realised it was unlikely to ever get called.
“WaMu is probably the most extreme case of extension risk being incorrectly valued,” says Mr Kushner. “This was priced in a flat yield environment, but what will happen to people who own that bond if the curve steepens out? That bond will then likely start trading off the 30-year treasury and the duration will go from four to something like 17 years. On a mark-to-market basis, that’s a trade that needs to be thought about very carefully.”
Ms Schildkraut-Katz is confident that investors understand this product and says that Merrill Lynch spends a lot of time discussing the terms of each security with investors so they understand what they are buying. US Bancorp’s Mr Bible says that both issuers and underwriters take this issue seriously. “These have a higher risk profile than senior debt so we’ve been spending a lot more time and resources on explaining these issues to investors with a lot more investor calls and Bloomberg roadshows to try to help educate investors.”
But Mr Kushner says there are some buyers in the market whose analysis of these deals is far too simplistic. “There are a lot of people who come in and do a fairly quick analysis and compare it with other issuers who have similar structures or to the senior unsecured debt of the same issuer. I think that a lot of times, that’s led to the wrong answer.”
Panic selling
The WaMu deal was certainly enough to spook the whole US hybrid market, which also started selling off. The NAIC verdict in March not only accelerated this process, but paused the institutional market altogether. Since then, spreads in this market have been slowly but steadily improving.
But with insurance companies, what one investor calls “the biggest elephant in the room”, temporarily out of the picture, issuers faced an uncertain reception and the likelihood they would have to pay investors considerably more for their trouble. “For the time being, it presents an opportunity for people like me who can take advantage of the recent spread widening to get more exposure to the issuers that we do like,” says Putnam’s Mr Murphy.
This all meant that Swiss Re, the first issuer to test demand from US institutions, was entering into pretty murky waters, particularly as it did not hear back from the NAIC about how it would view its deal before it was launched. Swiss Re’s $750m perpetual bond, part of a $2bn hybrid acquisition finance package to buy GE Insurance, was priced at the beginning of May and seen as a litmus test for the institutional market.
It was a success in that it was increased in size from $500m, despite the fact that hardly any insurance companies bought it. “The Swiss Re deal was announced without an NAIC rating and as such was targeting the other 70% to 80% of institutional investors,” says Mr Van Der Knaap at UBS, which, along with JPMorgan and Bank of America, was a bookrunner on the deal.
As it was issuing simultaneously in Europe, Swiss Re could afford to test the appetite from US institutions, avoid the insurance bid, and still do the bulk of its financing in Europe. However, it was priced at a discount to where new issues were coming before the NAIC debacle – Swiss Re paid 170bp over treasuries and about 90 basis points more than where its senior debt was trading, whereas US Bancorp paid less than 50 basis points more than its senior debt for the three enhanced trust preferred deals it issued before the NAIC decision.
Strong demand
Bankers say there is still healthy demand from pension funds, hedge funds and money managers, and that the pipeline is strong. Morgan Stanley says it has more institutional deals in the pipeline, following last month’s for insurer Lincoln National, which it bookran along with Merrill Lynch and Citigroup. However, bankers may find that institutional demand will not remain so robust. Lincoln National’s deal, an $800m institutional hybrid due 2066 to help refinance the bridge loan the company took out to fund the acquisition of Jefferson Pilot, priced at 185bp over treasuries. It had been looking to issue up to $1bn, so the company obviously was not bowled over by demand
Hedge fund investors like Mr Kushner say they might be less willing participants long-term without the liquidity provided by insurance players and Mr Murphy agrees that, without insurance companies able to play, volumes in this market are likely to be stunted.
The alternative is that deals can be placed with European institutions or in the US retail market. “We think the volume estimates are pretty much in line given the attractiveness of the retail market,” argues Kevin Ryan, executive director responsible for the US capital market product at Morgan Stanley. “It was a bit of market misconception that there was going to be a tremendous amount of volume in the institutional market in the first place.” Yet as another banker points out, the US retail market is pretty much running at full capacity already and could never absorb deals as big as Wachovia’s or Washington Mutual’s. “The hard part with retail is that you just can’t do $2bn.”
So where does the market go from here? A climb-down from the NAIC will get insurance companies back on board, but it is not in the interests of investment banks – or issuers – to make these bespoke transactions more uniform for the benefit of investor clarity. In fact, the banks are spending a lot of time honing their proprietary structures and Morgan Stanley, for one, will soon launch a European-style perpetual bond that doesn’t look like ECAPs or any of the other deals that have already been done.
Kevin Conery, preferred analyst at Merrill Lynch, thinks that, as with all new products, it could be another year before these new hybrids issues are easier to compare on a relative basis. “I think in this case there will be a greater deal of diversity, but I also think we’ll see a more standardised structure than there is now,” he says. “ It’s just tough to say exactly what that structure is going to look like.”
Market goes on
There’s no doubt that issuers will want to do more of these deals. The same demand for new regulatory capital, acquisition finance and a better weighted average cost of capital are still compelling. Mr Bible at US Bancorp, for one, wants to refinance $1.1bn more of its Trups that are callable in the fourth quarter, if he can. He thinks the market is still there for quality issuers.
Hopefully he is right, but analysts are already saying some of the much anticipated issuance of new hybrids may have to be pushed back to 2007 after such a long pause in the institutional market. For issuers, underwriters and rating agencies, the promise of the new hybrid market has been severely dented already.
