Hybrid debt: US issues are no longer a basket case

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Hybrids will drive investment-grade issuance this year. The emergence in mid-December of Burlington Northern’s $500 million hybrid debt transaction via Merrill Lynch and Goldman Sachs indicated that the first US corporate hybrid, issued by Stanley Works the previous month, was not a one-off.

In November toolmaker Stanley sold a $450 million 40-year non-call five-year issue via Citigroup, Goldman and UBS called enhanced trust preferred securities (E-Trups) to finance its planned acquisitions of Facom Tools and National Manufacturing. This is just the start in the US of a theme that had already developed in Europe.

Hybrid debt in Europe is a story of constant innovation; first by banks, then insurers and finally corporates. CFOs and treasurers like hybrids because, although they are similar to equity, they are a much cheaper form of capital and offer tax deductibility.

The trigger for the takeoff of European corporate hybrid issuance during 2005 was a change of stance from the rating agencies. Standard & Poor’s more accommodative stance on allowing equity credit for debt securities in 2004 triggered a hybrid bond for France’s Casino. In February 2005 Moody’s Investors Service relaxed its position, and there followed some €5 billion of corporate issuance as well as a host of deals from financial institutions, which incorporated features to receive equity credit from the ratings agencies. For once the European debt market has been ahead of the curve.

Europe takes the lead

“In the US, unlike in Europe, it took us longer to develop a transparent structure that issuers and investors were comfortable with,” says John Dickey, global head of the new products group at Citigroup. Dickey explains that US tax guidance meant that perpetual securities with non-cumulative payment deferral would not be deemed to be debt in the US, thereby prohibiting tax deductibility.

Consequently US hybrid securities have only gone out as far as 60 years – long enough to assure the rating agencies that they are a permanent form of capital. In addition to other structural features, Moody’s will provide Basket D treatment for a 60-year tenor, Basket C for a 50-year, and so on. Of course these deals have five-year or 10-year calls that, in addition to coupon step-ups, provide investors with a level of comfort that they will get their money back.

FIG subordinated bond issuance ($ mln)
Source: Dealogic
“A lot of issuers will use hybrids for strategic acquisition financing, to raise funds to repurchase common stock and to fund their pensions,” says Dickey.

Although the market’s attention was grabbed by the entrance of two US corporate names, back in August Lehman Brothers got the first hybrid structure that was acceptable to the ratings agencies and also tax deductible. The enhanced capital advantaged preferred security (Ecaps) was a $300 million floating-rate note (78 basis points over Libor) with a 60-year maturity but with a step-up and call after five years. It got into Moody’s Basket D bucket, which corresponds to 75% equity treatment, and received a 100% treatment from S&P and Fitch. Stanley Works got Basket C for its 40-year issue.

Variations on a theme

Lehman syndicate official Victor Forte says that all the transactions so far have been simply modified to meet rating agency stipulations, a specified level of equity treatment or structural nuances for tax deductibility.

“We’ve been taking what the rating agencies have said is required for high equity-content securities and marrying that with making tax-deductible securities,” says Forte. He explains that there are a multitude of structures including the use of trusts, limited liability corporations and direct issues. At present there is a lack of consistency in the tax advice from legal counsel. This will complicate the US hybrid landscape because every new deal has to be tailored to meet the specific needs of the issuer, jurisdictional requirements and replacement capital agreements. The Lehman deal used an LLC structure, which was very straightforward from a tax perspective.

Sooner or later investors will express a preference for one structure over another. They will have plenty of paper to choose from.

Reinsurance Group of America came with a 6.75% $400 million deal via Lehman Brothers and Morgan Stanley (structuring adviser) that eschewed an LLC or trust. It is in Moody’s Basket D and obtained 100% equity credit with S&P. Tax counsel gave the structure a ‘should’ opinion, as opposed to a ‘will’ opinion, that reflected that particular counsel’s general stance on hybrids rather than the RGA structure. Either a ‘should’ or ‘would’ tax opinion is typically acceptable for issuers. However, for investors the subtle difference can be important. If a security is not debt then it pays dividends not coupons. And offshore investors risk 30% withholding tax on dividends. For that reason, RGA took the conservative position that it was better not to market the deal offshore.

Zurich Financial Services used a trust for its Ecaps $1.3 billion dual-tranche private placement via Citigroup, Lehman Brothers (structurer) and Goldman Sachs and also got a ‘will’ opinion on tax deductibility. Some 30% of this transaction was sold offshore and garnered $3.2 billion of orders.

Citigroup’s Dickey explains that with some $60 billion of trust preferreds issued by US banks callable in the next two years it will be a very busy market.

“It’s possible that corporates will try to pre-empt the rush of financial institutions that are expected in the next year,” Dickey says.