Why corporate hybrids are not all they’re dressed up to be

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: SContreras@Euromoney.com

By:
Peter Lee
Published on:

Every market participant has had something to gain from corporate hybrid securities. Bond fund managers have delighted in high yields; issuers have enjoyed cheap equity. Ratings agencies have been paid for their trouble, investment banks have pocketed juicy fees and traders have revelled in the volatility. But what seems a perfect fit might well fall apart at the seams in an unfolding credit downturn. This will either expose the defects in the market and destroy it or validate hybrids as an asset class.

History of corporate hybrids: How did we get here? | Future of corporate hybrids: Where are we going?

THE LUNCHTIME CONVERSATION has ranged widely over the advantages for corporate issuers of the new breed of hybrid securities, which investment banks have been championing since the summer of 2005 as the next great thing in capital raising.

Ratings agencies regard these subordinated, perpetual or very long dated bond deals as comprising between 50% and 75% permanent equity capital on the balance sheet. Accountants agree. Maturities can extend and coupon payments be deferred, so providing a loss-absorbing cushion to senior creditors. Yet tax authorities treat the high coupon payments as debt-like interest costs to be paid from pre-tax earnings. And hybrids don’t dilute existing shareholders.

It’s a dream combination.

Over his aperitif, the banker has enthused about hybrids’ potential for financing goodwill on acquisitions, helping bidders stretch their offer prices and funding corporate pension liabilities – all while shoring up credit ratings. Over the main course, he has talked earnestly about lowering companies’ weighted average cost of capital and boosting shareholder returns. It’s only a wonder that more companies haven’t already sold them.

For investors, though, the high yields on these subordinate instruments have to compensate for a lot of risk and uncertainty. And now, as the waiter hovers with the bill, the talk finally turns to negative convexity and asymmetric payoffs. In a bull credit market, with low absolute rates and historically tight credit spreads, hybrids offer much-sought-after extra yield. But in a bear credit market, they might perform far worse than any other debt instrument in an issuer’s capital structure and, in certain circumstances, worse even than the equity.

To the investment banker, this is self-evident. “Oh, these are among the most toxic instruments we’ve ever created,” he says. “And they’re absolutely a bull market instrument. In a bear market, it’s not a question of maybe losing just a percentage point. You can lose 10 points in a heartbeat,” he warns.

So why have investors been buying hybrids? The banker’s look seems to ask how many more times he must explain the blindingly obvious. “Because they’re irrational,” he says. “But you probably shouldn’t quote me saying that,” he adds as an afterthought.

No, probably not. He has, after all, just proudly proclaimed that his firm has several hundred investment bankers around the world busily talking up these instruments to potential issuers. “There are guys pitching this for me who normally don’t want anything to do with debt, because it isn’t cool,” he says.

It’s cool now. Ask any investment banker and they’ll tell you the same thing: today, along with M&A, hybrid capital raising is item number one or two on the agenda that coverage officers want to raise with corporate customers. It’s not hard to see why. The case for issuing is pretty compelling. And investment bankers have their own incentive to argue it strenuously. Fees on corporate hybrids often go undisclosed. Some investors that have bought them aren’t aware of the fees arrangers are taking. The standard is 1% for institutional deals in Europe. That is many times more than for a conventional bond. And these are big deals. Of the nine corporate perpetuals launched in Europe from the start of 2005 to mid-March 2006, five have been for €1 billion or more.

For retail-targeted deals sold to private banks in Europe and to retail buyers in Asia, fees range from 2% to 3%. In the US, standard fees come in at 3.15%.

So there’s plenty in it for the arrangers, although the CEOs and CFOs of investment banks might care to reflect that they are playing a close to zero sum game. Hybrids are essentially one high-fee product competing with another – straight equity and convertible bonds. The arranging bank might not come out very far ahead if an issuer were simply to choose a hybrid over an equity raising – although it might benefit by getting paid twice if companies were to issue hybrids and buy back other capital instruments, equity or debt.

Lower down the ranks, it’s a fair bet that friendships between bankers in debt capital markets and those in equity capital markets are being strained as never before. One originator pulls a face as he chats to Euromoney about the product. An email has appeared in his inbox from an ECM colleague about a joint call the two are due to make on a client. The ECM banker wants to talk about a convertible. The debt originator, of course, has something else in mind.

Issuers pile into the arbitrage

There’s plenty in it for the issuers too. They’ve realized that hybrids are not expensive debt; they are cheap equity. That’s why French construction company Vinci was willing to persist with its €500 million deal through nerve-wracking primary market conditions this February, to lock in flexibility in its funding for the acquisition of toll road operator ASF (Autoroutes du Sud de la France).

It would have been an easy deal to pull. French media company Thomson had sold a similarly structured hybrid a few months earlier that had been poorly received. Then, as the roadshow for Vinci kicked off, Thomson issued a profits warning and the trading price of its hybrid fell by another six or seven points. Amid a bout of anxiety on a possible turn in the credit market, at least one investment-grade bond issue had to be postponed. Vinci and its lead banks toughed it out and completed their much riskier trade. They chose to talk only to those investors that had provided early expressions of interest during the roadshow for a credit that stands to benefit, following the acquisition, from stable cashflows on long-term road concessions comprising up to 65% of its ebitda. They kept the order book open for just three hours and reduced time to settlement to discourage shorting.

Christian Labeyrie, Vinci’s CFO, explains the strategy. “The main reason why we preferred a hybrid to ‘cheaper instruments’ such as convertible bonds or standard senior bonds is the equity content attached to it, which either may not materialize (in the case of a convertible) or does not exist (in the case of a senior bond),” he says. “In addition, in terms of cost, you should not directly compare hybrid and senior pricing but rather compare this hybrid with a mix of a 50% straight equity (non-tax deductible) and a 50% senior bond. You will then deduce that we made the right decision from a cost perspective.”

Hybrids offer issuers a hefty arbitrage between the equity treatment they receive from rating agencies and auditors and the price bond investors charge them for that capital. Every investment banks’ analysis shows a substantial discount on the cost of hybrid capital versus the blended cost of a proportionate amount of straight equity and senior debt adding up to the same total amount. So an issuer whose cost of equity capital is 9% and after-tax cost of senior debt is 2.7% might sell a hybrid comprising 75% equity for 3.7% after tax. The cost for raising the same amount in a proportionate combination of pure equity and debt would be 7.4%.

Peter Sass, DWS“Technical issues of supply and demand may somewhat overshadow the fundamentals.”
Peter Sass, DWS
That’s a massive arbitrage. There are only two possible explanations for it. Either the rating agencies are being arbitraged – allowing themselves to be persuaded to give equity credit for what, in economic terms, is really debt capital on which issuers will pay principal and interest, as if they were fixed charges. Or investors are being arbitraged – receiving debt returns for equity risk. The ratings agencies, at least, have an economic incentive to keep this market going. They get paid to rate these complex deals. So maybe it’s investors who need to look more carefully at what they’re being sold.

Either way, issuers are licking their lips. And although most of them are seeking the cover of a significant corporate event to introduce hybrids – funding an acquisition or a pension liability – they would be happy to make them a permanent feature of their capital structure. Labeyrie says Vinci would “certainly have considered such an issue away from the context of the acquisition of ASF, for instance as a way to reduce cost of capital”.

In the US, issuers have explicitly set out to reduce their weighted average cost of capital with hybrids. Railroad company Burlington Northern Santa Fe, for example, issued $500 million-worth of hybrids last December to fund share buybacks. In the US, there’s a growing urgency among companies to boost returns to shareholders through fine-tuning capital structures, after two or three years when improving business operations and deleveraging took priority. One reason to do it: to reward shareholders and reduce the chances of being subject to a leveraged buyout bid.

Occasionally investment bankers will allude to the ratings agencies’ rule of thumb for how much of a bank’s capital is the maximum they can stomach in hybrid form: 10% to 15%. Will the typical A-rated or BBB-rated corporate balance sheet be transformed in this way over the years to come? That depends on the appetite of the buy side.

What’s in it for the buy side?

So what’s in it for bond investors? That’s simple. “Investors are in a low-yield environment and are yield-hungry,” says Raphael Robelin, manager of the investment-grade bond fund at BlueBay Asset Management. “On top of that, many investors have strict investment guidelines. In the investment-grade universe, these are the yieldiest bonds one can buy.” He continues: “Some of these perps yield north of 6%. To get a similar yield on a senior security, one would need to look at BB-rated issuers or even single B-rated. But many investors are restricted from buying non-investment-grade securities.”

Many of the issuers that have so far sold deals have senior ratings in the region of single A or BBB+. Their hybrids are typically notched two ratings lower at BBB–, still investment grade but only just. Robelin concludes: “In any case, I’d rather take subordinated debt of a high-quality issuer, which I fully expect still to be around in 20 years, than senior debt of a much weaker name.”

He’s not alone. All buyers of hybrids agree that the key decision for them to take is on the underlying credit of the issuer. Only after they become comfortable with that is it even worth analysing the structural risks inherent in a new type of instrument in which no common template yet exists. “I don’t want to come across as a great bull on hybrids, in fact as a firm we are generally very cautious on new products,” says Robert Mead, head of European investment grade at Pimco. “But in any capital market there should be a spectrum of risk and return. And if there’s a gap between senior debt and equity risk that these instruments can fill, then we welcome that. If you feel positive on a credit whose senior debt offers Libor plus 40bp and you can get Libor plus 200bp for going down the capital structure, then that’s worth looking at. An extra 200bp or 300bp in spread on a 10-year instrument should enable you to withstand a lot of volatility over short periods and still come away with a decent return.”

Bankers and even some investors often draw a comparison with the market for subordinated bank capital, which took two or three years to establish itself at the end of the 1990s. Back then, the same argument was made: better buy a subordinated bond of a strong bank than the senior bonds of a weaker bank. That argument paid off. Over time, the bank capital market has gone mainstream and spreads have ground in. Banks that were paying Libor plus 250bp for such funky capital at the start of this decade might pay Libor plus 60bp for it now.
But it’s a comparison to be very, very wary of. Banks are highly regulated and protected institutions. The larger ones, the ones too big to fail, are a contingent liability of the sovereign. And they are in the business every day of paying and collecting interest or principal. Skipping a coupon or a call date is almost unimaginable, so damaging would it be to a bank’s core business. One Scandinavian bank once missed a coupon, amid the economic downturn in the 1990s, but this turned out to be an administrative oversight.

Corporates, by contrast, go bust. They walk away from obligations when they feel the risk of doing so is less than the damage of meeting them. They are entirely different to banks and much riskier. Who were some of the corporate issuers of redeemable and perpetual preferred stock, a forerunner of today’s hybrids, in the US that suspended payments during the last credit downturn? Guess who. Enron, WorldCom, Global Crossing. Preferred holders recovered the same as equity holders: nothing.

Are investment-grade bond buyers, then, being naive in underpricing this form of corporate capital? Dazzled by the higher yields on these instruments compared with conventional bonds, have bond investors failed to appreciate the risks? One could be forgiven for thinking so.
Another investment banker at a different firm lets slip a revealing comment on the types of buyers that were crowding the primary market for the transactions launched last year. “We became quite worried when some of the very smart, credit-savvy hedge funds first started showing an interest in these deals.” Oh really, why so? “Because we thought they’d short the shit out of them.”

In fact hedge funds were buyers last year. But the banker is right to suggest that among sophisticated credit fund managers there now seem to be more sceptics than enthusiasts. His peer at another firm even warns against talking to them. “They’ve gone short hybrids,” he says. “It’s in their interest to talk the market down and kill it”. Maybe. Of course, it’s in his interest to talk it up.

What does European Credit Management make of the hybrid sector? “It’s not a particularly desirable product,” says Joe Biernat, head of research at the firm, which, since its foundation in 1999, has grown funds under management to $21 billion. “I’d sum it up as non-investment-grade bonds dressed up in investment-grade clothes. We’ve invested small amounts in a few of the early transactions and so the investment banks are all over us about every new deal. We felt some of the utility deals were safer. But many of them are highly dangerous, given the current level of M&A activity. I suppose it might have a future as long as there’s a chase on for yield. But I don’t look at it as core.”

It’s not immediately clear who the natural buyers of corporate hybrids are or whether they should be a core investment for anyone.

Certain transactions, notably unrated Porsche’s $1 billion perpetual non-call five deal launched in January 2006, have clearly been sold to retail buyers in Asia. Casino, which set the ball rolling on the new wave of European corporate hybrid issuance in January 2005, with a €600 million non-call five deal, also sold it to Asian retail. Similarly TUI, the Ba2/BB+ rated German tourism company and the first non-investment-grade issuer of a hybrid, roadshowed its B+ rated, A300 million perpetual non-call seven hybrid in Asia last December and attracted plenty of retail orders in a strong book. The TUI deal rallied in the immediate aftermarket and tightened by almost 100bp in its first three months. The deals placed with retail have generally performed well.

Symbolic of the lack of sophistication of retail buyers, most retail deals offer short call dates, but no step-up in the coupon if issuers leave them outstanding. Pure institutional deals tend to offer at the least a 100bp step-up.

The retail bid was strong in certain of the supposedly institutional-targeted deals last year. This is not just Asian retail buyers but also private banks in Europe, seeking extra yield for their wealthy clients. Hedge funds and bank trading desks have been prominent. And although Euromoney has found many real-money institutional buyers, many of these appear to have been taking short-term trading views.

“We do not think that hybrid debt is suitable as a buy-and-hold instrument so they are often not appropriate investments for real-money long-term funds intended to match liabilities,” says Ian Robinson, head of credit strategy at asset managers Foreign & Colonial. “We’re also wary of putting them in any portfolio where, if they go non-investment grade, we would be a forced seller. We do take some short-term bets in performance funds and it is these as well as high-alpha funds that are the keenest to participate.”

Are real-money fund managers only buying because they think they can boost their own performance in the short run – for which, of course, they get amply rewarded – with some extra yield before selling out quickly to a greater fool before their own clients have to suffer big capital losses? “Understanding who else owns these bonds and what their strategy might be is very important,” says Pimco’s Mead.

“At the moment, technical issues of supply and demand may somewhat overshadow the fundamentals,” says Peter Sass, director and senior portfolio manager at asset manager DWS in Germany. “Certainly we have clients who can stand higher volatility and want high coupons and can accept subordination and perpetuals or long-dated maturities. And we are active portfolio managers. Clearly there has been strong retail demand – though not strong enough, I suspect, to fill some of the very large order books on these deals.”

Beware the liquidity trap

William Healey, chief investment officer at Picus Capital Management, believes he’s seen this film before. It doesn’t have a happy ending. “It’s a potential liquidity trap,” he says, “the kind we’ve seen plenty of times in the past. Remember auction rate notes and trust preferreds in the US in the late 1980s and early 1990s? Remember step-up perpetuals in Europe a few years later?” Each of these markets, he suggests, depended on a narrow investor base taking essentially the same directional view at the same time when credit conditions were benign. Everyone wanted to buy until, suddenly, conditions changed and everyone became a seller. And then liquidity evaporated.

Healey continues: “If you look at the TUI deal, for example, I think the investors in that transaction are very different from the people who have been used to buying and trading TUI’s CDS and conventional high-yield bonds. The core, end investor base for these instruments [corporate hybrids] is very narrow and we think it’s not in Europe. It is the Asian bid which, for yield product, is insatiable until the very moment when suddenly it isn’t. Some European investors have treated them as a short-term play with long duration which they can trade out of for some total return, because dealers are now providing decent liquidity. But the moment the dealers themselves can no longer lay off their positions to that Asian bid, they might not be picking up the phones. The jaws of the liquidity trap can snap shut.”

So while investors have been thinking about credit risk and structure risk and agonizing over whether they can model the spread required to compensate for the different combinations of subordination, extension risk, coupon deferral risk and volatility of trigger ratios in the convoluted hybrid structures they’ve been presented with so far, maybe all this was a distraction from the biggest worry of all: liquidity risk.
What could be the trigger for the jaws to snap shut?

The two worst things that could happen to an issuer, from the hybrid investor’s point of view, is that it should default or that it should be subject to an LBO. In a default, senior creditors will regain some value, maybe 30% of the face value of their original loan to the company, maybe 40%. But hybrid investors, like shareholders, will probably get nothing.

In an LBO, shareholders will get bought out at a premium. The value of their shares – representing voting control and ownership of, potentially, a growing stream of future dividend payments – will shoot up. The value of hybrids will shoot in the opposite direction. Private equity buyers’ only interest is to maximize the value of their equity stake. The hybrid sold by the previous owners can become a zero coupon perpetual for all they care. Bond investing 101 suggests that’s definitely not a good structure to own.

Now, at a time of extreme aversion to LBO risk among holders of conventional bonds, with investors insisting on change-of-control covenant protection in new issues, it’s going to be very difficult to insert similar protection into hybrid bonds – which stand to perform far worse than senior bonds in an LBO – lest the ratings agencies view these as de facto final maturities that invalidate equity content.

For some of the first hybrid issuers last summer, these risks do look remote. “You’ve got to ask yourself, is a company like Vattenfall or Dong going to default,” points out Simon Surtees, corporate bond fund manager at Gartmore. The Vattenfall and Dong hybrids are the darlings of the sector. Vattenfall is 100%-owned by the Swedish government and rated A–. It generates, distributes, sells and trades electricity in the Nordic region and has ambitions to expand, presumably through acquisition, in Europe. Its reason for selling the hybrid was the difficulty of raising equity capital without diluting its sovereign shareholder. Similarly, Dong (Danish Oil & Natural Gas), another acquisitive Nordic utility, is owned 100% by the state of Denmark. And although it might sell down part of this holding before the hybrid hits its call date, the Danish government is likely to view it as a key strategic asset, even if it owns just over 50%.

Each might gear up for further acquisitions – and the Vattenfall hybrid requires the issuer to defer coupons if a key and volatile credit ratio is impaired – but it seems unlikely their state owners will let either of them go bust or be the subject of an LBO. These have been the good deals to own, although even these have been volatile when speculation on acquisition plans has mounted. Vattenfall launched at a spread to benchmark of close to 204bp, traded in to 135bp in October before widening again towards 150bp over in February. Dong came at 229bp over and rallied to 173bp in February.

The potential gains can be counted in several percentage points. But the poor performers have done worse. “There is a substantial differentiation between Dong and Vattenfall on the one hand and the non-regulated industrial issuers on the other but these are all high-beta instruments,” says Susan Swindells, portfolio manager at Fischer Francis Trees & Watts, a specialist fixed income fund manager for institutional clients.

It’s hard to find any institutional fund managers who run hybrid positions for many months. Hybrids are not a sleep-soundly-at-night sort of investment, although they might have uses for shorter-term trading positions – going long one deal and short another. Swindells explains: “I would rather play relative value as an overlay strategy on some of our corporate bond portfolios, as we do not have a strategic allocation to hybrids as an asset class.”

Many investors have put on spread compression trades to play the potential for Dong to trade much closer to Vattenfall, which it came flat to in March 2006, before widening out again by between 10bp and 15bp.

Even for utility credits with stable cashflows and state ownership, the structures give pause for thought. Nigel Sillis, head of credit research at Baring Asset Management, says: “I remember working through the documentation on Dong and coming to the realization that, though it would require extraordinary circumstances, the issuer could opt never to pay a single euro cent of cash interest or a single euro cent of principal and still not be in default. And the final legal maturity on that deal is 1,000 years from now. Yes, it’s difficult to imagine the conditions for that to happen... but it’s possible.”

Danger signals

German company Südzucker is Europe’s leading sugar processor. It issued a €700 million hybrid last June and tapped it for another €200 million in September, shoring up financial ratios that had been hit by earlier debt-financed capacity expansion and acquisitions. Then in November 2005 came announcements of forthcoming changes to the EU regulatory regime for the sugar industry that would reduce protections in a sector already suffering as consumers became more diet-conscious. This led Moody’s to place the A3/A– rated company under review for possible downgrade. Spreads widened on the hybrid, which is rated BBB– and would fall to junk if Südzuker’s senior rating is notched down, from 219bp at launch to 275bp last November. It has rallied almost as sharply since, coming back in to 220bp in March.

Südzucker was a jolting ride for buyers. But it was nothing compared with their experience with the Thomson hybrid.

Sometimes you just have to sit back and admire investment bankers’ chutzpah. Investors have already had their early warning of the dangers of hybrid securities in the dire performance of the issue for the French media services company.

“We’re not miles away from fair value”
Robert Mead, Pimco
Robert Mead, Pimco
With the benefit of hindsight, Thomson does not fit the profile for an ideal hybrid issuer. As well as decent yields and clean structures, investors now say they want sound, stable, companies with predictable cashflows and a low likelihood of being LBO targets. Thomson’s largest single shareholder is a private equity investor and in the six months since its €500 million perpetual non-call 10 issue last September it has put out two profit warnings. “I went to the roadshow and I couldn’t really work out what these guys did,” says a source at a large UK bond fund manager. Its hybrid has cratered and now trades on price not spread – the classic sign of bond market distress – at around 80.5% of face value in early March (remember “10 points in a heartbeat”). That’s up from its low point in the mid-70s.

Euromoney managed to find one investor who would admit – not for attribution – to having owned Thomson hybrids. At times they have rallied, often on speculation that the company might be a target for acquisition by a stronger-rated trade buyer. “We bought in the mid-80s hoping a bit of momentum might carry them up,” says the fund manager. “We threw in the towel in the low 80s. I wouldn’t touch them again. If that thing gets LBO’d, the next print will be in the 50s.”

So when an investment banker at a third firm pulls out his pitch book for hybrid securities, Euromoney looks first at the chart on trading performance of outstanding issues. Something seems to be missing. Where is the Thomson deal? “Oh we took it off,” explains the banker airily. “It was making the whole market look bad.”

As well as credit risk, investors in hybrids are taking structure risk in instruments riven by the tension between on the one hand assuring ratings agencies that companies can, in extremis, fail to pay interest and principal and not default and, on the other, assuring investors that interest and principal will, in fact, be paid. “It’s a tightrope that everyone is walking on this,” says Barbara Havlicek, chair of the new instruments committee at Moody’s.

Thomson shows how ugly it can be when an issuer falls off.

Partly because it is subject to French tax regulations, Thomson’s hybrid featured optional, non-cumulative deferral of coupons. Investors like deferral of coupons to be at the issuer’s option, rather than mandatory if a certain financial ratio trigger is breached. But they don’t like non-cumulative deferral, whereby missed coupons are not subsequently made good. So that combination was a mixed blessing.

Matters became more complicated as fears about LBO risk heightened in the second half of last year. Thomson was pressed to add some reassurance for investors by including a 500bp coupon step-up in the event of a change of control. Issuers cannot give investors a put option in the event of an LBO partly because this might look like a poison pill to any bidder but mainly because Moody’s will not accept investor puts on deals seeking equity treatment. So the 500bp step-up was designed to give comfort. But instead of reassuring investors it drew attention to the fact that the step-up might never be paid given the issuer’s option of non-cumulative deferral. From the very outset, things went wrong for that deal.

And even though subsequent issues have succeeded, including Vinci’s, which also included optional, non-cumulative deferral, pricing these deals, with all their interdependent credit and structural risks, is more witchcraft than science.

Every market participant acknowledges that, in the early stages of market development – when few issues are outstanding, trading histories are short and there is a lack of comparables – pricing cannot be exact. “It’s the Wild West,” says one fund manager. But can it be argued, by reversing the compelling weighted average cost of capital analysis shown to issuers, that they have been seriously mispriced? “We’re not miles away from fair value,” is the answer of Mead at Pimco. “When you look at yields that are higher than dividend yields on the stocks and a multiple of senior spreads, we’re at least in the ball park. Sometimes deals get brought to market that are so obviously expensive or cheap that our response is an instant ‘no’ or ‘yes’. This sector isn’t like that. The very least it deserves is a full assessment of both issuer fundamentals and security specific risks.”

Investors tend to look at simple metrics: the multiple of the hybrid spread over the same issuer’s 10-year CDS spread. A five times multiple might look cheap, three times might look expensive. It’s an approach the technical analysts decry. And if any firm has devised an efficient ratio for hedging long hybrid positions by buying protection through the same issuer’s 10-year credit default swaps, Euromoney has yet to see it. The basis risk – you’re not hedging like for like – and the multiples of CDS protection required make it expensive insurance that might not really cover you.

Spurious accuracy

Most of the lead bank arrangers have had their research departments produce models that price up corporate hybrids’ credit migration risks, extension risk, subordination risk and coupon deferral features and spit out theoretical fair values against which prevailing spreads are judged rich or cheap, so as to encourage buying and selling.

It’s an entirely reasonable intellectual exercise. But the models offer a spurious notion of accuracy, and investors aren’t buying it. “The trouble with the models,” one fund manager says, “is that they don’t work.” They may be valid tools for assigning required spread to individual risk features and combinations of them. But they’re not much use if the market spread obstinately refuses to mean-revert to the model. That has been the experience so far. “Of course the model might be right and the market might be wrong,” says the fund manager. “But as the old saying goes, ‘the market can stay wrong for a lot longer than you can stay solvent’”.

And there are much bigger issues unresolved than minute adjustments for the potential net present value at risk on a cumulative deferral given a ratings migration probability from BBB– to below investment grade in a deteriorating credit market.

“The valuation implications between treating these hybrids as 10-year instruments or as true perpetuals are night and day,” says Swindells at Fischer Francis Trees & Watts. These instruments are trying to be debt and equity at the same time. Most participants in the financial markets have grown up believing the two are irreconcilably different. Can they be half equity? Can you be half pregnant? So there’s plenty of potential for confusion and therefore huge inefficiencies in pricing.

“In our view, these should be viewed by investors as 100% credit instruments,” says Jonny Goulden, quantitative credit research analyst at JPMorgan. “Investors will get their cashflows, unless something happens to impair the credit. People say they are equity risk, when what they mean is that hybrids have high potential volatility. But there is nothing equity-like about them, from a valuation perspective.”

Eric Cherpion, director of Eurobond syndicate at Société Générale Corporate & Investment banking, takes a different view. “It [hybrid] features a lot of risks which are similar to those of an equity product,” he says. “You’re selling equity risk to bond investors. Many of these investors have to take into account that a product featuring equity risk will tend to behave like an equity, featuring a higher volatility than the typical senior corporate bonds; hence the superior return that those bonds are offering.”

On February 24 2006, Morgan Stanley’s credit strategist in Europe, Neil McLeish published a research note, Implementing a bearish view, that laid out explicitly what many have been saying for months. The firm is moving to a material underweight on European credit markets with a view that there is a two-thirds probability of spreads blowing out by 20% by May or June. McLeish sees weaker technicals, the inverted US yield curve and the obvious rise in LBOs and leveraged takeovers by corporates as a fundamental shift.

Eventually the young corporate hybrid market will be severely tested by a credit event, a skipped coupon, maybe even a default, more likely an LBO (“the next print will be in the 50s”). Whether it survives is partly a matter of timing. If that credit event comes several years hence, after many issuers have sold deals, traders have maintained liquidity amid periods of risk aversion, investors have seen differentiation and captured good returns, then the market might survive. If it happens this year, then it probably won’t and it will die amid much finger-pointing and bitter recrimination.

So will this market still be around in 10 years when the first issues approach call date? The banker, replete after his lunch, shrugs on his coat to face the cold London day and blows out his cheeks. “Who knows?”

How do you price a corporate hybrid
Hybrid spread vs CDS
Why corporates may not call their hybrids
Call incentive through credit spread increase
Source: Citigroup