The subordinated bond market for financial institutions written off as dead at the end of 2008 made a spectacular comeback last year and proved an extremely popular way for issuers to either repay state aid or, through liability management, repair their balance sheets.
From retail buyers to institutional investors, there was willingness in backing banks subordinated debt raising efforts as risk appetite returned.
"The transparency created by the stress tests in the US helped start the healing process," says Siddharth Prasad, head of FIG capital markets and financing at Bank of America Merrill Lynch. "US banks started to raise capital and we began to see a normalisation in the markets.
"The pace of the healing accelerated in July when we saw concerns about systemic risk alleviated with more clarity around banks balance sheets."
While many transactions could be used to illustrate the recovery of the subordinated bond market, the Lloyds Banking Group £7.5bn issue of Enhanced Capital Notes (ECNs) done in November 2009 is perhaps the best example.
The groundbreaking liability management exercise conducted by the UK bank enabled bondholders to swap out of their hybrid tier one and lower tier two holdings for the new instruments, which although classifying as lower tier two, automatically convert to common equity if the banks core tier one ratio falls below 5%.
Market participants expect this new form of capital to play a big role in 2010.
"Contingent capital as stress capital will be important," says Sandeep Agarwal, head of European FIG DCM at Credit Suisse in London. "Contingent capital that provides capital at times of distress, preferably in a non-dilutive form but more importantly at an acceptable post-tax cost of capital, is what will ensure it develops as a meaningful asset class. The regulators will need to give it a defined credit in the capital structure to encourage issuance."
This view is echoed by regulators and bankers across the globe who see contingent capital as a way to make banks balance sheets more bullet proof in times of crisis.
"2010 will be focused on striking the right balance between what the right type of capital is, how much should a bank have, its cost and the liquidity banks will have to run," says Richard Boath, co-head global finance EMEA at Barclays Capital.
"There will be a lot of attention on what the right number for equity tier one should be and what other types of capital are included and whether they are of any use. This is where contingent capital comes in and although it is dated, it does what capital is supposed to do which is to absorb losses in order for a company to survive."
However, many questions remain unanswered, including what the natural investor base for the product will be.
"There is a lot of noise around the new generation of hybrids such as the ECNs and what the right structure should be for those," says Laurent Frings, head of credit research at Scottish Widows Investment Partnership. "There is still a lot of work to do and what will be critical for the asset class is the depth of appetite. The regulators are pushing for this type of extra cushion to be put in on top of banks core tier one. At the end of the day, however, they need to sit down with investors and issuers and discuss what works for everyone."
The success of the Lloyds exercise, which 75% of investors with non-impaired securities participated in, indicated that there would be a potential future and an investor base ready and willing although it should be pointed out that investors were faced with an offer they found difficult to refuse on account of the fact that Lloyds had been prevented from paying coupons on certain existing securities for the next two years by the European Commission.
The fact that the Lloyds exchange was quickly followed by Yorkshire Building Societys decision to issue similar instruments as part of a financing package that backed its merger with Chelsea Building Society showed that there was potential use of contingent capital beyond impaired securities and troubled institutions.
Like the Lloyds deal, Yorkshire will issue convertible notes that qualify as lower tier two, have a fixed coupon but automatically convert to Profit Participating Deferred Shares (PPDS) if the mutuals core tier one falls below 5%.
But while contingent capital will feature in this years discussions and could become more mainstream, financial institutions will have other pressing issues in 2010.
"The big challenge for issuers in 2010 is that they will be faced with two different sets of regulatory reforms," says Gerald Podobnik, co-head of capital solutions at Deutsche Bank. "In Europe, it will be the implementation of the Capital Requirement Directive (CRD) which will be made into national law at the end of October and needs to be enforced by January 2011. Issuers will need to comply with this and the intention of the directive is to reach a level playing field for banks in Europe."
One of the aims of the CRD is to standardise the type of hybrid tier one instruments that European banks can issue. Part of this standardisation will involve a greater focus on loss absorbency characteristics of hybrids.
Regulators believe hybrids have failed to play their supported loss absorbency role during the crisis.
Furthermore, the European Commission was very active last year in enforcing its concept of "burden-sharing" and stopped banks with state aid on board paying coupons on their hybrids whenever possible. The aim of the upcoming regulatory changes is to make this concept more enshrined in the language of hybrid bonds.
"The cost of issuing hybrids under the proposed CRD will be greater given the additional loss absorption features required for new hybrid tier one instruments," says Prasad. "This is partly why banks have looked at issuing the old-style instruments and will continue to do so, especially with the grandfathering regime in place."
From 2020, banks will only be able to issue 20% in instruments that do not qualify under the new CRD rules. From 2030, it will be 10% and from 2040, no old instruments will be allowed.
David Marks, chairman of FIG debt capital markets at JPMorgan, thinks that cost will not be the only motivation to issue. That they are tax-efficient and the investor base already exists for them will also be motivating factors.
"What we will see is a continuation of the theme where banks compete and strive to avoid further slugs of state aid like Lloyds or move to repay state aid like we saw the French banks do in 2009," he says.
Crédit Agricole was one bank to use the hybrid market extensively and raised Eu3bn through three different markets in order to repay state aid. Intesa Sanpaolo was another bank which came to the hybrid market and raised Eu1.5bn of hybrid tier one, to avoid state aid.Overall, issuers raised almost $22bn equivalent in the market (see graph). While this is a smaller amount than in previous years, it must remembered that most of the issuance happened from July onwards following the re-opening of the market by Crédit Agricole and Standard Chartered which kick-started proceedings with deeply subordinated hybrids targeted at private banking networks primarily in Asia but also in Switzerland.
While there was something of a hiatus after those two deals, issuance recommenced in earnest at the end of August, showing the enduring popularity of traditional hybrids for banks, but also investors looking for yield.
It is not just at the European level that banks will have to contend with moving regulatory goalposts. "At an international level, the discussions within the G20 and the Basle committee are reviewing the definition of capital," says Deutsche Banks Podobnik. "This will have an impact in the coming years and in conjunction with EU CRD implementation, makes for a potentially complicated situation in terms of the regulatory framework and how banks manage that."
Just like in Europe, the push internationally has been for higher levels of capital with a focus on equity and more of it. But bankers believe that this is unlikely to be achievable.
"I think the story about hybrids losing their place in a banks balance sheet is a little bit overdone," says Credit Suisses Agarwal. "I cant see equity investors as the only providers of capital required by banks and my gut feel is that there will need to be a certain amount of fixed income instruments on banks balance sheets to pare down cost of capital and manage ROE expectations. You simply cant ask all the capital injection to come from the equity market, especially when the bond market is three times the size."
JPMorgans Marks questions whether banks will want to maintain high core capital ratios of 8%-9%. "While in the depth of the crisis, banks have moved towards a much higher plateau, I am not convinced that next year those banks that have predictable risk profiles will see a rationale in having such high core tier one ratios, which is where contingent capital becomes relevant," he says.While hybrid tier one could stay in play, the future of lower tier two, an asset class that has already shrunk sharply (see graph), is still in the balance.
"Lower tier two as a way of providing leverage to banks balance sheet is gone," says Prasad. "In 2009, for the first time ever we saw more tier one capital being issued compared to tier two. Tier two as an asset class still has a role to play in managing deductions and may reinvent itself as the favoured host instrument for contingent capital issuance."
Liability management on the wane?
One of the themes that played such a large part in 2009 but unlikely to feature as much for banks this year is liability management. Banks spent most of the last year buying back their subordinated outstanding debt, in most cases at a discount, a process which created the holy grail of whole capitals: core tier one.
It was a win-win situation as banks were able to buy debt back cheaply and for investors, it was their get-out clause, at a premium, for what had become a very distressed asset class. For those concerned about extension risk, it was also a way to exit securities where there was uncertainty around whether the issuer would call them.
This type of liability management will not continue at levels seen in 2009.
"Liability management is not dead," says Vinod Vasan, head of European FIG DCM at UBS. "What has gone is buybacks at a discount but there will be other things like debt restructuring. Having liability management in 2009 meant that issuers went in and put a bid in the market, which was instrumental to the recovery of the subordinated market."
So while it is clear that market participants believe that hybrids, in whatever shape or form have survived 2009 and will be a big part of 2010, they question how deep investor appetite will be, especially if spreads compress further.
"One of the key questions in 2010 will be how investors react to declining absolute yields in financial institutions; whether that encourages a renewed rotation down the capital structure and into lower rated credit, or alternatively into other asset classes altogether," says Richard Howard, head of FIG syndicate at JPMorgan in London. "For the moment, the value proposition remains attractive, even among senior financials, when compared to similarly rated corporate credit"
Mark Geller, head of FIG syndicate at Barclays Capital, echoes this view."For the most part, investors feel that the worst has passed for financial institutions and there is a huge amount of cash out there," he says. "While the spread environment has compressed this year, there is still value in financials and potential upside."