Corporate bonds: Hybrid corporate debt makes its mark


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Subordinated debt gives treasurers a new means of raising equity capital

Several years of corporate deleveraging and balance sheet repair would appear to be at an end. This June the euro corporate market boasted its biggest monthly volume since June 2003 (€19 billion versus €24.75 billion) and its most dynamic new development since the 50-year sector was opened and shut by Telecom Italia in March.

Corporate treasurers have long envied counterparts at financial institutions. Via their ability to issue hybrid tier 1 capital instruments, banks – and more recently insurers – have boosted capital without diluting equity. These regulatory capital instruments have grown ever more popular following their approval by the Basle Committee, but unregulated entities such as corporates were not under the same stimulus. Furthermore, rating agencies failed to provide clarity on what was needed to provide explicit guidance on what was permissible.

Early attempts to get a hybrid corporate market off the ground had stalled as a result of inadequate investor interest, and issuers had received little credit from rating agencies. These included, in 2003, a €400 million issue for Linde and one worth €500 million for Michelin – but neither of these received much recognition from the agencies. In the past year, Casino managed a €600 million bond but this was retail targeted. The dynamics have changed now, with €2.7 billion of institutional paper printing in a little over a week during June, from three issuers. With all of these enjoying great demand, the market has finally got off the ground.

According to Eirik Winter, co-head of fixed-income capital markets Europe at Citigroup, to work for issuers these transactions require the "ability to raise significant volume. To have a meaningful effect on the balance sheet you need size." Last month's biggest bonds, from Swedish state-owned energy company Vattenfall and Danish Oil and Natural Gas (Dong), were for €1.1 billion each. Winter points out that there have not been many €1 billion-plus senior corporate issues in the past year.

Winter is enthusiastic. "Look at the Vattenfall issue," he says. "It has a 5.25% coupon on an instrument that receives equity treatment under IFRS, is tax deductible and achieves equity credit from both Moody's and S&P."

Ander Lidefelt, president of Vattenfall Treasury, says: "It increased our financial flexibility or, if you like, our debt capacity and at the same time maintained a constant average cost of capital."

This is the only way Vattenfall, as a 100% state-owned company, could easily boost equity capital without asking for state handouts. It also benefited from the support of Moody's and S&P – both have their long-term senior ratings on positive outlook. In fact Moody's explicitly linked the hybrid deal with its outlook decision [see Market round-up, this issue]. The end result is that the Nordic utility will be much better placed to undertake acquisitions and remain true to its aim of remaining a single-A rated company.

A Deutsche-led €800 million trade for Südzucker got the show on the road. Aside from high investor liquidity, it was clear what has driven such a major change in circumstances.

"It's different, now you have a framework from the rating agencies. Before it was a debate. It is now very transparent," explains Francois Bleines, head of corporate syndicate at Deutsche Bank. He adds that although there was a complex discussion with investors about the trade-off between rating and price, as well as discussions about the credit profile, the market was extremely receptive to the transaction.

Equity features affect the marketability of the instruments and raise the cost of capital. "It's a new tool for corporates either for ratings maintenance, enhancement or M&A financings," says Bleines.

It is noteworthy that corporate subordinated offerings have so far been made by companies that have family or state ownership dynamics where raising equity capital can be problematic. But all corporates are averse to dilution.

Südzucker was keen to bolster capital ahead of a regulatory review on the EU sugar industry. Vattenfall appears to be a candidate for M&A activity, while Dong is expanding in the Swedish, German and Dutch gas markets.

So were investors appropriately rewarded for the subordination? It seems that there was no shortage of buyers. Südzucker was 25% oversubscribed, Vattenfall's deal was twice covered while Dong had three times as many bids as paper – €1.1 billion – on offer.

The extra pick-up over debt that investors received relative to senior 10-year paper was trading ranged around the 150 basis points mark. But this varied according to the degree of equity features.

"I think it's a good thing for the market – as long as you are comfortable with the company and comfortable with the reward you are getting for the extra subordination," says Peter Bentley, portfolio manager at Pimco in London.

These are aggressive instruments, with mandatory interest deferral language on the Südzucker and Vattenfall securities.

Before the deal, Vattenfall's hybrid securities were rated at Baa2/BBB– A3/A– at senior. It qualified for Moody's equity basket D and received 60% equity credit from S&P. It was Südzucker, with a A3/A– senior rating, that had the ratings headroom to be aggressive from an equity perspective, qualifying for basket C and 60% respectively and receiving a Baa2/BBB– rank. Most debt-like was Dong, which was basket D and 50% equity credit. Dong's slightly more bond-like structure sprang from its need to retain a subordinated investment-grade rating of Baa3/BBB– compared with Baa1/BBB senior.

For those familiar with bank hybrid debt issues these structures are relatively straightforward. The bonds are perpetual but callable after 10 years – if they are not called the coupon steps up by 100bp.

For tax reasons Dong has a 1,000-year maturity with a call in year 10. It has no mandatory trigger but the coupons are cumulative and employ an alternative coupon settlement method if interest payment cannot be made.

Obviously there is a danger for bondholders in buying such a security – after all 10 years is a long time and no-one can predict whether 100bp will be a significant penalty in 2015 for a borrower to pay. However, the reputational impact of not calling would be significant for a long-term, regular user of the debt markets.

"Vattenfall benefited from being seen as a regular user of fixed-income markets over the past decade," explains Peter Charles, corporate syndicate at Citigroup.

In reality this is just like any other form of corporate credit. As investors get more comfortable owning crossover credits and there is less aversion to holding paper that is close to the cusp of investment-grade these issues will be even easier to sell than they have been in the past month.

"We cross-referenced the buyers, they are the classic hybrid capital investors," says Fred Zorzi, co-head of European syndicate at BNP Paribas. "When we started it was not obvious we could get to this size."

Winter predicts: "There are a lot more companies that will do this." However the market is immature and serious challenges are likely to arise. "The next test will be when we see a cyclical corporate," says Zorzi.