Hybrids: ANZ cuts non-innovative premium

As more and more borrowers reach the 15% limit (of total tier-1 capital) for so-called innovative debt – that is, bonds with coupon step-ups – issuing non-innovative hybrids is the only option remaining.

Traditionally only retail investors have felt comfortable with the extension risk that the lack of a coupon step-up at the call date theoretically results in. Over the past three or so years, the sheer depth of demand for credit has encouraged institutional investor to accept this risk. However, they have demanded a premium

The ANZ deal, led by Citi, Deutsche Bank and UBS, takes advantage of the fact that Australian issuers are able to have features where the security converts into shares provided there is a limit to the amount of equity dilution that occurs at that point. So the bond has a mandatory conversion at year five subject to these dilution limits. If the mandatory conversion breaches the conversion limit, then the bond resets at the same spread for another five years.

This feature allows the bond to continue to qualify as tier 1 because conversion results in the security being replaced with high-quality equity capital. This structural feature gives investors confidence that the bond is highly likely to have a five-year maturity, with there being a small risk of extension in the event of a very poor share price performance by the bank. Of course if the share price was performing so badly, it is quite possible that the regulator would not allow a bond with a coupon step-up to be called anyway.

There is another interesting structural aspect to the deal. Because fixed-income investors do not relish the prospect of receiving equity, ANZ included a resale facility that results in the shares being sold and investors receiving cash instead.

All of this meant that ANZ printed at gilts plus 96 basis points – a spread equivalent to 51 basis points over sterling Libor. Bankers estimate that this amounts to a 5bp to 8bp saving for the borrower.

Geoff Tarrant, head of the capital solutions group at Deutsche Bank, suggests that this structure could possibly be applied to the UK and Netherlands where there are similar regulations. Of course, some issuers would not like the possibility of having to issue shares as they would be uneasy about possible dilution and there are also potential earnings per share considerations.