Investors hungry for higher yields have embraced hybrid securities, with hybrid issuance for both corporate and financial instruments increasing sharply in the past two years, despite the risks. 

Declining yields on every front have made riskier forms of debt more attractive to fixed-income investors, with hybrid securities a major beneficiary. Yet while primary markets for both corporate and financial hybrids have been booming, they remain vulnerable to any return of risk aversion.

Bank hybrid issuance was on hold until the latter part of 2013, at least in Europe, while details of the new regulatory regime were finalised. So it was corporate hybrids that began to seriously engage the attention of investors, and therefore issuers, in the course of 2012. And then 2013 turned into a blowout year.

Corporate treasurers like hybrid securities because, being equity-like, they allow companies to defend their senior ratings and raise capital without diluting shareholders. They also tend to be cheaper to issue than a combination of equity and debt. The trouble was that large corporates could never issue in sufficient size to ‘move the needle’, as they liked to say.

Powering up

Then, at the beginning of 2013, French utility EDF showed what could be done. It issued a massive €6.2bn equivalent in corporate hybrid securities in two euro tranches plus one US dollar and one sterling tranche, having built an orderbook of more than €23bn. Investors and treasurers alike suddenly readjusted their ideas about the market’s capacity for corporate hybrid and the way it could be used.

Other utilities and telecommunications companies have since been prominent issuers, using the capital to repair their balance sheets and fund projects. EDF itself returned to the market this January with another multi-tranche series of hybrid deals raising €3.9bn. Unusually, the sterling tranche extended the non-call period to 15 years. The hybrids were part of a mammoth €7.5bn equivalent package that included tranches of US dollar senior debt.

At much the same time, Italian utility Enel came to the hybrid market – not for the first time – to raise €1.6bn of hybrid capital, while French telecoms operator Orange made its debut with a €2.8bn deal.

While the bonds’ maturities are typically 60 years or more, and are often perpetual, issuers can call them early. They are subordinated to other debt instruments and issuers may be able to suspend coupon payments without triggering a default. In return for this additional risk, hybrid issuers must pay a premium to their senior debt. But investor demand has allowed corporates to issue more and more cheaply. Coupons on EDF’s January 2014 offering ranged from 4.125% to 5.875%. Later in the year, German utility Energie Baden-Württemberg was able to price €1bn of hybrids paying only 3.625% on two separate occasions.

M&A route

Corporate hybrid issuance in Europe, the Middle East and Africa (EMEA) rose from a mere $7.7bn equivalent in 2012 to a record $37.7bn in 2013, according to Dealogic. In the year to date it has already reached $34.6bn. The year’s final tally may depend on one very specific use to which hybrid finance can be put – mergers and acquisitions (M&A).

M&A has spawned a lot of recent hybrid issuance. German carmaker Volkswagen chose this structure to raise €3bn to complete its takeover of Swedish truck manufacturer Scania in May. In June, German pharmaceutical firm Bayer issued two hybrids worth a combined €3.25bn to help finance its acquisition of Merck. The bonds paid 3% and 3.75%, respectively, and the orderbook was more than three times oversubscribed.

Orange returned to the hybrid market in September with a €3bn equivalent deal in euros and sterling. The aim was to help pay for its purchase of Spanish broadband operator Jazztel. Orders were in excess of €11bn, and Orange said that the overall cost was 4.5%, below the average cost of its existing bonds.

Risks remain, although not always in the most obvious places. Steelmaker ArcelorMittal rattled the market earlier this year when it repaid $650m of hybrid debt less than 18 months after it was issued. What really upset investors was that it redeemed the bonds at 101 points, even though they had been trading at 108. Both ArcelorMittal and Telecom Italia called their bonds because they had been downgraded to Ba1 by Moody’s – and Moody’s does not grant 50% equity treatment to sub-investment grade issuers.

Shifting ratings

Equity treatment is all important to corporate issuers of hybrid bonds, and the shifting views of ratings agencies have made some borrowers more reluctant to issue. Full 100% treatment has become harder to get, and most recent issues are structured to qualify for an intermediate 50%.

AJ Davidson, head of hybrid capital EMEA at RBS, thinks that, with some structural innovation, higher equity treatment is possible. “For Moody’s it would be easy to achieve 75%,” he says. The necessary adjustments would include mandatory cancellation of coupons on a non-cumulative basis, tied to a metrics-related trigger.

This year’s total issuance of corporate hybrid should certainly equal last year’s and may well exceed it. For now, at any rate, it is business as usual. “As M&A picks up, we continue to see a steady stream of issuance, which is being well received by the market,” says Simon McGeary, Citi’s head of new products, debt capital markets.

A certain amount of issuance is built in for next year too. The ratings agencies expect hybrids to have ‘permanence’ in the issuer’s capital structure, and to be refinanced once they are called. JPMorgan has identified calls of $14bn equivalent coming up in 2015 and another $7bn in 2016. If M&A continues at its present rate, that would support further issuance.

Year of the bank hybrid

If 2013 was a golden year for corporate hybrids, 2014 should prove at least a silver one for bank hybrids. Hybrid issuance by financial institutions in EMEA hit a low of $26bn equivalent in 2012, while European banks waited for Basel III’s stronger capital requirements to become law in the shape of the Capital Requirements Directive and the Capital Requirements Regulation, together known as CRD4. Issuance increased to $33.1bn last year. Since CRD4 took effect from the start of 2014, year-to-date issuance has already passed that mark, at $36.9bn, and there is likely to be another wave now that the results of the European Central Bank’s Comprehensive Assessment have been published.

CRD4 says banks must hold common equity Tier 1 capital equal to 4.5% of risk-weighted assets. Another 1.5% may be additional Tier 1 (AT1) loss-absorbing capital – it could also be equity, but banks are invariably going for the cheaper AT1 option. They also need 2% of bail-inable Tier 2 capital plus additional buffers. Citi estimates that major European banks require some €150bn of AT1 capital, prompting issuance of perhaps €30bn to €40bn a year for the next four or five years.

Structures must choose which loss-absorbing mechanism to incorporate – equity conversion, temporary or permanent write-down. They must also choose between high and low loss-absorption triggers of 7% or 5.125%. Last year’s early issuers included KBC Bank and BBVA, which chose equity conversion, and Credit Suisse and Crédit Agricole, which opted for permanent write-down. Rabobank, a mutual that cannot convert bonds into shares, used a permanent write-down feature.

High rewards

Crédit Agricole kicked off this year with its inaugural US dollar AT1 deal, printing €1.75bn off an orderbook approaching €25bn. Investors took to the risky new instruments with enthusiasm, drawn by the high rewards – at the start of this year a high-quality issuer could achieve about 6.5%, but coupons tightened from there.

Santander, which had irritated investors with some opportunistic liability management, was nonetheless able to attract €17bn in orders for a €1.5bn transaction paying 6.25%. Danske Bank printed a €750m deal with a coupon of 5.75%.

Early AT1 issues had been principally in dollars, bought initially by Asian private banks and then by US institutional investors. But euro-denominated issues have become commonplace and, while some thought sterling would not be fertile for AT1, UK building society Nationwide disproved that with a £1bn ($1.61bn) AT1 lookalike deal that priced inside where a dollar or euro issue might have priced.

The collapse in June of Portugal’s Banco Espírito Santo led to its Tier 2 bondholders ending up in the ‘bad’ bank, which reminded investors that there are real risks attached to subordinated capital. This pause for thought, and a fall in AT1 prices, caused Banco Popular Español to pull an AT1 deal planned for early July.

The market was reopened later in the year by Santander with its third AT1 transaction of the year. Compared with the delirious reception accorded its first deal, this €1.5bn offering in September attracted only €3bn. The bank insisted on printing the full €1.5bn and the bonds traded down in the secondary market. Investors had worked out that banks are going to be issuing hybrid securities for some time to come, and that they did not have to be in every deal, particularly on the third time around.

UniCredit likewise ran into some stubbornness on pricing, and had to price its €1bn AT1 offering some 25 basis points higher than expected, at 6.75% on orders of €2bn.

Still peaking

Was the market past its peak? The next deal showed that the answer to that was an emphatic ‘no’. HSBC reawakened investor passion for the asset class with its long-awaited AT1 offering. The $5.7bn equivalent transaction had a non-call 10-year and a non-call long five-year dollar tranche, alongside a euro tranche, with respective coupons of 5.625%, 6.375% and 5.25%. The bonds featured a 7% trigger (UK regulators do not approve of the 5.125% variety) and equity conversion. This was the largest single AT1 deal to date and it drew orders worth $30bn equivalent. And the bonds traded up in the secondary market.

Nordea, another quality issuer, may have looked at Santander and UniCredit and decided to keep its visits to a minimum. It raised much of its full AT1 requirements in its debut outing, raising $1.5bn in two tranches, a non-call 10-year (preferred by US investors) and a non-call five-year (for the Asian market) with coupons of 6.125% and 5.5%. Those were the lowest yields so far for a dollar trade. Orders of $11bn were logged, and Nordea has laid down a marker for other Swedish banks such as SEB, Svenska Handelsbanken and Swedbank to follow.

Issuance from China is imminent. Bank of China has been marketing the first offshore hybrid from the jurisdiction in the form of preference shares (China does not permit perpetual debt) with a 5.125% trigger. In Europe, however, Nordea was followed by a lull, partly in the run-up to the Comprehensive Assessment results and partly because markets have been in risk-off mode. Germany’s Aareal Bank roadshowed an AT1 deal in September but did not launch a transaction immediately after.

“Banks are in a blackout period,” says Citi’s Mr McGeary. “They know broadly what their asset quality review [AQR] results are, but they can’t say anything about them. So there is a natural gap in issuance until the other side of the AQR. And the macro backdrop is choppier.”

The market is anything from two to four points lower than when HSBC issued. There have been further fears about global and emerging market growth, and markets continue to be unsettled by the ebola outbreak, war in the Middle East and the Russia/Ukraine situation.

So while banks will continue to issue subordinated debt to meet their regulatory obligations, it seems that the initial investor euphoria has subsided. “In the first half, it was one-way traffic in terms of performance,” says Christoph Hittmair, HSBC’s global head of financial institutions group debt capital markets. “Deals were consistently pricing tighter. But investors have started to question relative value, to look at the fundamentals and take a step back in assessing these transactions.”

Banks themselves have some concerns. One is that the amount of total loss-absorbing capital required from systemically important banks could be higher than expected. For now, the ratio must be 10.5% by 2019, but the Financial Stability Board will unveil a new number at the G20 summit in Brisbane in November. Stories doing the rounds say it could be up to 20%.

A worry specifically for UK banks lies in Bank of England proposals, still under consultation, to change the way its leverage ratios are calculated. This, banks fear, could limit the amount of AT1 capital that counts towards the ratio and effectively increase the capital they are obliged to hold.

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