Hybrid corporate bonds might be the new hot product of the Eurobond market but originators’ hopes for a deluge of new issues have not been fulfilled. Far from it – just a handful of public deals have hit the market since the start of the year.
Of course any new product takes time to catch on, and it is certainly not for want of trying. But it appears that the marketing techniques of investment banks have left treasurers dazed and confused rather than champing at the bit.
One corporate treasurer recently told Euromoney that he had received 18 unsolicited proposals for a hybrid transaction from investment banks. He thought that eight of these came from “credible” institutions (he declined to categorize the other 10). Even so, the range of spread indications that these eight banks then offered on the pitches was incredibly wide – as much as 60 basis points from the tightest to the widest.
That lack of consensus undermines treasurers’ confidence in awarding mandates. Having a clear idea of fair value is extremely important for funding officials as they do not wish to be associated with mispriced transactions.
Add to that other uncertainties and the reasons for ignoring the pitches multiply. Many treasurers are still struggling to comprehend the corporate finance angle of hybrid debt, such as: is this expensive debt or cheap equity? What will the proceeds be used for – possible M&A or to bolster credit ratings? Are there sufficient internal (treasury) resources to be comfortable in conducting such a transaction?
All hybrid structures are refined to suit borrowers’ needs and, given the lack of a European-wide legal/regulatory framework, heterogeneity is guaranteed. And although new issues came to the market in early summer, the sector lacks the maturity or range of transaction type to provide benchmark pricing for new issues.
So how can banks and their clients evaluate fair value? It helps if a borrower has a liquid senior bond to provide a yardstick. It is then a matter of adding on basis points to compensate for subordination. Another take on this principle is to calculate the hybrid as a multiple of the senior spread. If there is no 10-year cash bond available, the 10-year credit default swap spread is used instead.
It sounds reasonable. But beware bank marketing. The recent €500 million hybrid for Thomson [see Euromoney October 2005] was priced at 3.16 times the issuer’s 10-year CDS spread. The multiple sounds carefully chosen. It was, but perhaps not for the reasons you’d think. Of course, 3.16 is the square root of 10.
And if treasurers have got it bad, what about investors? Ultimately the more a hybrid security resembles equity and not debt, the more spread that is needed to compensate investors. But even evaluating those features is not straightforward as it is very difficult to compare one hybrid structure with another. Take, for instance, deals from Danish Oil and Natural Gas and Thomson. Both of these transactions got the same equity treatment from Moody’s/S&P (Basket C/50%) And yet they offer quite different risk for investors: Dong’s coupon payments are cumulative, while Thomson’s are non-cumulative.
Some argue that to develop properly this market needs utility and telco issuers not more difficult or obscure credits. But it seems more likely that forthcoming hybrid issues will come with a credit story attached. Almost every M&A pitch contains a hybrid structure in the financing plan.