The closing weeks of 2009 were characterized by repeated warnings that the debt capital markets had not learnt the lessons of the previous two years and that investors were leaping back into risky products in a simple chase for yield. The only real surprise, however, is how quickly this happened. And more bull market instruments are set to see the light of day again this year, among them corporate hybrids.
At the peak of the last cycle corporate hybrid issuance reached roughly 9 billion or 5% of the corporate market. But even at the markets height protagonists were well aware of the risks involved. Speaking to Euromoney in early 2006 one commented: "Oh these are among the most toxic instruments weve ever created they are absolutely a bull market instrument. In a bear market it is not just a question of maybe losing a percentage point. You can lose 10 points in a heartbeat."
And so it proved. But corporate hybrids are now poised for their comeback depending on the outcome of Moodys imminent revision of its approach.
The FIG hybrid tier 1 market came back in 2009 with deals from a range of banks including Standard Chartered, Nordea and Intesa Sanpaolo. But the instruments are in the regulators sights: just before Christmas the Basle Committee called for the phasing out of innovative hybrid tier 1 capital although it did recognize the useful role that hybrid capital plays in the tier 1 bank capital base.
If corporate hybrids make a comeback, important changes to their structure will have to be made and the rating agency approaches to both bank and corporate hybrids are being revised to reflect this.
In order to get equity credit, hybrid instruments need to get as close to common equity as they can and that means being perpetual. Most rating agencies regard 60 years as a perpetual maturity but the agencies will now be far more stringent about having replacement covenants at redemption rather than just step-ups. And investors have indicated their unwillingness now to accept step-ups alone in creating a synthetic maturity.
Another area under review is stock settlement. Standard & Poors permits stock settlement (which renders the instrument economically non-cumulative) in very limited circumstances. Moodys is reviewing its approach and observers believe that the agency might feel that it has given too much credit for stock settlement in the past and so might tighten its rules as part of its new approach.
The rating agency could release its changes to hybrid equity credit as early as February but will probably issue a request for comment first. Investors should now be more aware of the risks associated with the product particularly extension risk, which is now much greater than it was before. But given their enthusiasm for other bull market products that have returned from the grave in recent months there will likely be another issuance cycle in corporate hybrids but driven this time by balance-sheet repair rather than M&A.