STRAIGHT EQUITY ISSUERS remained in hibernation this
spring but hybrid capital issuers woke up to inviting
conditions.
Issuers have found that low interest rates, tightening credit
spreads and the continued volatility of the equity market make
hybrid products across the spectrum from subordinated debt
structures to hybrid convertibles highly attractive. Yield-hungry
investors have shown a big appetite for the extra basis points
offered by subordinated debt from credits with which they are
fundamentally happy. And the strong demand for convertibles from
long-starved convertible arbitrage hedge funds has helped issuers
get away with some bargain terms.
Siemens, for example, offered a coupon of just 1% and a premium
of 46% for its e2.5 billion seven-year convertible on May 22. The
issue, managed by Morgan Stanley and UBS Warburg, is the largest
European convertible since Fiat's $2.2 billion exchangeable
offering into General Motors in December 2001.
In April, Munich Re attracted e6.3 billion of demand for its
record-breaking e3 billion 20 non-call 10 subordinated bond, the
largest single-tranche subordinated straight ever. It was followed
by a slightly upsized £300 million 25 non-call 15 subordinated
bond.
Given the conducive market conditions and
flurry of recent deals, UBS Warburg estimates that hybrid
capital issuance in 2003 could reach e43.1 billion, up 39% on
2002.
Retail demand has featured strongly in recent deals. Bookrunners
BNP Paribas, HSBC, and Merrill Lynch were overwhelmed by the demand
for Old Mutual's May 12 retail-targeted Baa1/A- perpetual hybrid
that came from private banking and retail clients in Asia, the
Middle East, and Europe. The planned $300 million transaction
attracted over $2.5 billion of demand even though the London-listed
South African insurer is not a household name. The bookrunners
marketed the deal over five days in Europe and throughout Asia by
video conferencing because of concerns about Sars. With a generous
8% coupon, the offer more than doubled to $750 million.
Landesbank Kiel also saw outstanding demand for its retail
Resparc (re-engineered silent participation assimilated regulatory
capital) tier 1 perpetual non-call six issue. The German Landesbank
had initially planned a e300 million issue but took advantage of
the e2.2 billion of orders to raise the offering to e500 million,
making it the largest euro tier 1 offering since 2001. UBS Warburg,
BNP Paribas, and Lehman Brothers, bookrunners for the issue, cut
the coupon by 50 basis points to 7.5%, saving e40 million for the
issuer.
"If you were trying to sell hybrid capital to European investors
in 1988 you'd hardly get the time of day," says David Marks,
managing director of hybrid products at JPMorgan. "The situation
has completely reversed now. If they're fundamentally happy with
the credit they want to go as far down the quality curve as
possible for the extra yield. It's almost harder to sell the senior
debt now."
But not everyone is optimistic that hybrid issuance will grow
much further. Financial institutions dominate hybrid issuance,
particularly of dated subordinated debt and perpetual hybrid
securities, but there is only a handful of institutions with both
the incentives and the regulatory capacity to issue substantially
more hybrid capital. Among European insurers, for which the ratings
benefit of issuing hybrid capital is the chief incentive, only ZFS,
Munich Re, Allianz, and Legal & General have both a strong
incentive (they are all on negative outlook) and substantial
capacity for more. Similarly, among major European banks only
Deutsche Bank, National Bank of Greece, Royal Bank of Scotland, and
UniCredito Italiano still have substantial
capacity.
Innovation breeds confusion
Financial issuers are being held back from greater and more
sophisticated use of hybrid capital for balance-sheet management by
a lack of clarity about the regulatory and accounting treatment of
hybrids. Basle II allows for up to 15% of a bank's tier 1 capital
to be composed of "innovative" hybrid capital, although it does
allow for more "non-innovative" hybrids. Confusingly,
non-innovative hybrids are actually the most structurally
innovative instruments.
The innovative/non-innovative distinction is where there is the
most regulatory uncertainty. The UK's Financial Services Authority,
to which European regulators traditionally look, changed its mind
about the non-innovative classification that it initially accorded
to Barclays Capital's Tons (tier 1 notes) structure. The Tons
structure was a breakthrough because it was the first directly
issued, core tier 1, tax-deductible hybrid to be classed as
non-innovative. It essentially enabled banks to raise non-dilutive
equity quality capital at about half the cost of issuing shares
beyond the 15% hybrid limit. While Tons deals that have already
been issued are unlikely to be affected, future issues will no
longer receive the same treatment.
Financial institutions group bankers in London are frustrated
with the lack of guidelines. "At the moment the FSA effectively has
no guidelines for what would be acceptable outside the 15%
innovative limit, and worse they haven't even made clear what
principles we should be working towards," says the head of FIG at a
US investment bank in London. Bankers are particularly annoyed
because hybrid products are one of the few areas of business making
money.
Regulatory or rating agency considerations may be the main
drivers of hybrid capital issuance but the accounting treatment of
hybrid instruments may affect the views of regulators and
raters.
There is concern from leading accountants that under the
International Accounting Standards due to be adopted by the EU in
2005, all SPV-issued hybrid tier 1 capital would be reclassified as
debt instead of shareholder funds. This is particularly galling as
after the FSA turned its back on its initial preference for
directly issued structures like Tons or RCIs (reserve capital
instruments) most bank hybrid capital has since been done through
SPVs.
The IASB is expected to finalize the controversial IAS32 rule by
next January. If SPV-issued hybrids are reclassified as debt, banks
with significant amounts of hybrid tier 1 could feel some
discomfort. And if overall tier 1 capital falls, tier 2 capital
falls with it. Banks in Europe are generally capitalized well above
regulatory minima, so it would not itself cause a crisis, although
a depleted capital base would leave them in a weaker position
should a crisis arise.