|In the Merrill Lynch US Hybrid Capital Roundtable the following panellists discussed the latest developments in this exciting and innovative asset class:|
|Peter Abramenko, managing director of the fixed income fund at Sigma Capital Advisors, New York||Peter Abramenko, managing director of the fixed income fund at Sigma Capital Advisors, New York||Wylie Collins, managing director and head of Americas debt capital markets, Merrill Lynch, New York||Barbara Havlicek, senior vice president, chair, New Instruments Committee, Moody's Investors Service, New York||Philip Jacoby, managing director and senior portfolio manager, Spectrum Asset Management, Stamford||Ken Nelson, senior vice president, corporate treasury division, US Bancorp, Minneapolis||John Price, managing director and co-head, Americas credit for trading and sales, Merrill Lynch, New York||Bill Scapell, senior vice president, director of fixed income and portfolio manager for the preferred securities portfolios, Cohen & Steers, New York||Jill Schildkraut-Katz, managing director and global head of the capital structuring group, Merrill Lynch, New York||Brad Stone, vice president and director of research, Flaherty & Crumrine, New Jersey|
Toby Fildes, managing editor, EuroWeek, and roundtable moderator
EuroWeek: 2006 is being called the breakthrough year for US hybrid capital. Is this an accurate description?
Schildkraut-Katz, Merrill Lynch: 2006 was a year of evolution, innovation, convergence, customisation, uncertainty and heightened investor demand.
Evolution centred on two structures originally developed in 2005 — the trigger-based structure and the cumulative instrument with a replacement capital covenant.
But there was also evolution of investor acceptance for the various features, evolution of Moody's views on what constitutes 'non-cash cumulative', and evolution in Standard & Poor's treatment of hybrids for corporate and financial institution issuers.
There was innovation, as two additional structures were introduced — the unit structure with a debt host and forward on preferred stock (borrowed from the equity-linked world) for internationally active US bank holding companies, and the structure which is 'non-cash cumulative' with optional deferral, where interest payments can only be paid from the proceeds of selling securities to the market pursuant to an alternative payment mechanism (APM) or alternative coupon satisfaction mechanism (ACSM).
Innovation was also seen with maturity shortening from a tax and/or investor perspective and/or maturity extensions for additional rating agency benefits.
We had convergence, as the utility and non-financial issuers gravitated toward the cash cumulative instrument with a replacement capital covenant. That was because they are never required to issue securities pursuant to an APM, the instrument is always cumulative on an ongoing basis and in liquidation, and it receives symmetrical rating agency equity credit.
There was customisation — even with convergence among certain structures, transactions still required an element of customisation to address issuer-specific needs or make the product as flexible or efficient as possible for each issuer. There is still no one-size-fits-all solution, nor do we expect one to develop, given each issuer's specific circumstances and the varying industries in which they operate.
We saw uncertainty, most dramatically caused by the NAIC — and most recently caused by the Moody's proposal to revise its notching policy.
And there was heightened investor demand — 2006 closed with the most robust market and broadest demand for hybrid capital from institutional and retail investors. Deal sizes grew, spreads tightened and the time it took to price a deal compressed.
EuroWeek: US Bancorp has been one of the most active users of the new generation of hybrid capital over the past year or so. Can you tell us about your experiences?
Nelson, US Bancorp: 2006 was a pivotal year for US Bancorp on a couple of fronts. In early 2005, Moody's had communicated its 'A-E' bucketing of hybrid securities.
Since the advent of trust preferred securities in late 1996, there had been little if any equity credit from the rating agencies. With some additional structuring, we now had an opportunity to achieve this.
In addition, early in 2006, USB moved its capital management targets from a tangible common equity model to a tier one capital and total risk-based capital ratio model.
Because we, like many other banks, had trust preferreds that were issued in 1996 and 2001 with 10 and five year calls, we had a great opportunity to maximise the efficiency of our capital structure by calling trust preferreds and issuing new hybrid securities, gaining more equity credit from the rating agencies and fitting our new tier one and total capital management model.
We began with a basket 'C' issue in December 2005 and followed with the WITS-ITs transaction early in 2006, followed by a non-cumulative perpetual preferred transaction and two additional trust preferred issues.
EuroWeek: How much investor education was needed for these new deals?
Nelson, US Bancorp: We and our dealers worked very hard with the investors to explain the structure, our motives, rating agency and regulatory issues. Independently the investors were going back to the rating agencies to learn as much as they could.
Schildkraut-Katz, Merrill Lynch: We have always considered investor education a very important part of the process. We did a lot of that work in the summer of 2005 as we knew the deals were coming and we wanted to make sure the investors would be up to speed.
But we also had to educate other dealers in our transactions before they were sold, to ensure they understood the features and could accurately explain them to their investors.
Price, Merrill Lynch: What also helped kick-start this market was in 2004 when Merrill issued a DRD [dividends received deduction] Libor floater. That attracted a lot of interest from investors. It was interesting to see how not only did institutional investors get it pretty quickly but also how retail investors were willing to look at the tax advantage these securities provide.
We are still doing the education process today but unfortunately the question has drifted from 'what is the spread I can get for subordination', 'and what is the call option worth', to 'how many bonds can I get?' This shows you how crazy this market has become!
EuroWeek: Did Moody's think the equity credit refinements in 2005 would have the effect that they have?
Havlicek, Moody's: Frankly I did not think it would have the impact that it has had. We saw it as an evolutionary and not revolutionary piece. The rationale was that the New Instruments Committee had seen a number of securities and the feedback from market participants was that we were being perhaps too conservative. For example, some securities only in a basket 'C' were more equity-like than equity.
We also had internal discussions about whether we should scrap the basket system and adopt a bifurcated system. If the security was supportive of senior creditors it would be equity, if not debt. And if non-payment of the distribution resulted in default then it would go into fixed charge coverage, if not then it would be excluded.
We thought the bifurcated proposal was all too revolutionary. Instead we decided that the market knew the basket system and that the best course of action was to tweak it. So there was a general shifting of the rankings that we assign to the various hybrid features in a more equity-like direction.
EuroWeek: How have the investors found the last year or so?
Scapell, Cohen & Steers: It's been kind of a harrowing experience. The number of different structures has been staggering. Over just the past three weeks we have looked at 22 new issues, and nearly every one offered a variation of some sort. It's a lot of work going through the documentation and picking out the small nuances unique to each deal and thinking through how the structures work.
It's especially important to understand these differences, given the current environment of tight spreads and a flattening yield curve. I think one of the challenges down the road will be what happens to these securities when the yield curve starts steepening and/or spreads widen.
EuroWeek: Has the arrival of hybrids changed your investment strategy or made you more adventurous?
Jacoby, Spectrum: It hasn't made us more adventurous but the market certainly is. It has made us more constructive because the subordinated elements of the hybrid product are what Spectrum has focused on for years.
Some of the new structures have been challenging because there have been so many variations and each one may present a different risk element.
Right now, we are at a time in the credit markets when no one seems to care much about risk — spreads are tight, volatility is low and investors are basically discounting risk into their afterlives.
This product is being bought by a lot of folks who do not remember when the preferred market was haunted by the ghost of the tax-man — or perhaps greed is such that they don't care, since momentum is for the moment.
I think a haunting will come again so we are making sure to buy the right paper. But in the meantime, we have a tremendous opportunity for this market to grow over the next couple of years.
The tax-deductible equity content is just too attractive to ignore for issuers and importantly, the hybrid market is built on firm fundamentals and reasonably good structures for investors. There is certainly no tax sham going on but rules can be changed to suit the popular mood — lawmakers have done it before and they will do it again!
Remember when Ways and Means threatened to deny the tax deductions on debt-financed LBOs in the late 1980s and when the Clinton administration threatened to eliminate the tax deductions on trust preferreds in the late 1990s? This is the ghost I am talking about, so there should be a sense of urgency for issuers to get it done now because all the stars are in alignment and buyers just cannot get enough adventure these days.
EuroWeek: What is the main factor driving your decision to invest in a deal — structures or the underlying credit?
Jacoby, Spectrum: Both. In fact, there are the basic portfolio needs for duration, credit diversification and yield. One of the nice things about the hybrid preferred market today is that there is five year, 10 year, perpetual, fixed rate and floating rate paper. Basically, lots of different opportunities for us to select what we need.
Abramenko, Sigma: Going back to your question about how we have found the past year, the changes by the NAIC created a huge opportunity. If we had not had those bumps in the road the spreads on hybrid capital and tier one capital would be much tighter than they are now.
Now that the NAIC issues have been resolved, temporarily at least, the market has become very comfortable with the basket methodology for subordination and it has become pretty comfortable with the valuation of these structures, adjusting for extension risk and the true subordination level in the capital structure.
The investor base is half way there to really being able to value these structures properly. So if this process continues the way it has, the implicit premium for valuation uncertainty will start to dissipate. Most of this should occur by the first quarter of 2007.
EuroWeek: When you say the investor base is half way to valuing hybrid structures properly, what are investors not quite getting?
Abramenko, Sigma: With these deals there are no set models for analysis. Each investor sits down on his own and does the analysis on where they should trade. So people are approaching these deals in different ways and there is not much consensus or framework.
EuroWeek: We're right in the middle of a bull market. Are certain structural features being mispriced?
Abramenko, Sigma: Investors are not as concerned as they might be with such things as extension and deferral risk in securities that have more onerous extension risk and a higher probability of interest deferral.
They are comfortable with the raw spread and the underlying valuation of the senior unsecured credit, but not as much with the valuation of the other structural components. Nonetheless, since by most measures financial institutions are in the best shape for 20 years and present very low event risk, most investors are willing to take on some uncertainty in the valuation process to get incremental spread.
So, while the securities in this asset class are undervalued overall, because of the inefficiencies created by the lack of an accepted valuation methodology, investor valuation of the relative impact of different structural features is all over the map — some are overvalued, while others are undervalued.
Jacoby, Spectrum: I guess I have a bit of a simplistic view towards the value of deferral features, whether it is cumulative or non-cumulative risk. I guess the bottom line is that cumulative versus non-cumulative is not significant enough to matter. I say this based on historical data we have looked at with respect to prior deferrals. We have gone back to 1993 [the beginning of the hybrid market] and found that there have been 19 issuers that have deferred in the hybrid corporate market which adds up to about $9bn in total capitalisation and of that $9bn, about $6bn has been accompanied by Chapter 11. So on the other side of that coin, about a third of the hybrid market has deferred without a Chapter 11 experience. Within that one-third, the data is heavily skewed by Southern California Edison and Tokai because of bad regulation in California and a technical deferral in Japan. So if you were to factor these companies out, there is about a 90% probability that a deferral will be accompanied by a Chapter 11 at which time all bets are off. Now with that being said, I think you can look to the CDS market for information on probability of default and as you go down the rating scale companies may be impaired or are just lesser credits and that is going to be weighed into the probability of expected default on senior debt. If we take the dynamic CDS default information and factor it with the evidence that shows us that 70%-90% of the time a deferral is also accompanied by Chapter 11, our opinion is that most of the credit valuation should be weighted in the loss-given default methodology — that is where the real meat of the valuation should be.
Stone, Flaherty & Crumrine: I agree with that analysis. There is little data to go on to determine what individual structural components should be worth.
But with many more issues now including optional or mandatory deferral, it is going to be interesting to see if deferral could become a more regular occurrence. I still think it is going to be relatively infrequent but the fact that it has not happened very regularly in the past does not mean it will not happen in the future.
So we have to think about who is the issuer, what is the probability that they are going to defer, and what influence the issuer's regulator is going to have on the decision.
EuroWeek: Do you differentiate between securities where the issuer can defer and pay deferred coupons in cash and those where it has to sell securities to the market to pay the deferred amounts?
Stone, Flaherty & Crumrine: The alternative settlement mechanism makes a difference, though if you get to the point where you have to use it things are probably not very good in the first place. But it makes it more likely that default and deferral happen at the same time.
Collins, Merril Lynch: I want to know how have investors' lives changed since this market has become so popular? With pools of money pouring in [to new issues] from traditional bond fund managers has it become harder to put your capital to work?
Scapell, Cohen & Steers: I find it less difficult because of the overwhelming supply of deals. That said, we have seen $4bn books for $400m deals, so allocation has got tougher. The market has, of course, got pricier, too.
Jacoby, Spectrum: I am a bit annoyed. Spectrum has been one of the ambassadors of the product for years, but now with all the demand from the new kids on the block I no longer get treated like that in syndicate!
Seriously though, we want our bonds. I am not someone who pads an order — if I want $100m I want $100m.
That said, it is a good thing to have growth in the market, a broader investor base and more liquidity and so forth. So I think it is a healthy evolution and one that we are just going to have to grind through.
But markets change. I remember in 2002 when nobody wanted to own a credit product. We will see those buyer's market days again, but right now issuers need to understand what a great time it is to be a seller!
I just really want to know whether people know what they are buying. Do hedge funds really know what they have bought for the momentum trade? Do they know how fickle DRD can be? What if the wonder of retail goes away?
We have a significant refinancing cycle coming up in the US in 2007 and it is yet to be determined whether that [money] can be reinvested in hybrid product. My gut says it can be because hybrids make so much sense to issuers today as inexpensive equity — this is something the market did not have 10 years ago. The market is also growing globally with great developments in Europe as well as Japan and Australia.
EuroWeek: Is there any difference between some of the standard bells and whistles in the States and those elsewhere?
Scapell, Cohen & Steers: The tier one market in Europe is advanced compared to the US. The Axa 12 and 30 year deals recently had complex provisions in them that were similar to what people have seen in Europe, but which were new to most US investors.
Schildkraut-Katz, Merrill Lynch: Structures are different country by country, taking into account local regulations, corporate structure, tax and corporate law.
EuroWeek: Moody's is proposing a two-step ratings process for hybrids. The first step would involve notching down from the senior rating to take into account the hybrid's likely higher loss given default. The second, and new, step would evaluate omission risk — the risk involved for an investor if an issuer is allowed to omit interest payments without triggering bankruptcy or reorganisation. Barbara: why do you think these proposals are necessary?
Havlicek, Moody's: In terms of rating the new generation of hybrid securities, we found that we have clear guidance about how to notch for subordination.
But when rating committees were sitting down to discuss hybrids which have deferral features some of them were saying 'should we being doing something around this risk?'
We wanted to make sure we have a consistent thought process around the way we notch for hybrid securities. For example, some of the bank deals with replacement capital covenants, optional deferral, ACSM settlement within five years and junior sub debt: those all were notched twice.
Why were they notched twice? Well, different rating committees would give different answers to the question as to whether or not we should be notching for deferral/settlement risk.
Some committees concluded that according to strict notching for subordinated debt it should have only been one notch but the market seemed quite comfortable with two notches.
We are trying to make sure we are consistent because in some cases we are notching twice for a certain structure and once in other cases. That was the main impetus for the proposal.
If we notch for the deferral/settlement risk associated with ACSM settlement, where either common stock or a certain type of preferred securities needs to be issued to the market in settlement of a deferred distribution, we do need to notch for non-cumulative settlement.
Abramenko, Sigma: If you take preferred ratings as a given and use them as one part of the band and you have senior debt ratings as the other part of the band, even though it may intuitively make sense to add some notching for deferral features, you run into the problem that these securities are senior to preferred in bankruptcy and that the probability of deferral is probably the same as probability of default, so how much are you really adding to the risk security by having a less attractive deferral feature?
What do you when your notching for both subordination and higher likelihood of deferral cause you to come up with a hybrid rating that is out of whack with the ratings on the company's non-cumulative preferred?
Doesn't this additional notching for less attractive deferral features sometimes almost force you to reconsider the preferred rating? By differentiating an extra notch for deferral probability for a cumulative bond with no ACSM versus a bond that has an immediate ACSM, you end with one bond that is rated like the preferred and one which isn't.
Intuitively, additional notching for a poor deferral feature seems to create a ratings inconsistency. I think that a cumulative hybrid which is senior to preferred in bankruptcy, but has a less attractive deferral feature — perhaps with no ACSM — should still be rated higher than a non-cumulative preferred.
So have you ever thought about the need to adjust preferred ratings or does this simply push you back in the other direction, namely rewarding a bond with an ACSM that takes care of the deferral within some defined period of time by taking away the need for the extra notching?
Havlicek, Moody's: I understand the point — it must seem to some that we are notching for a factor that seems a miniscule risk.
But there is some risk — we have done some back-of-the-envelope research on the probability of default. Our thinking was that if there is deferral, the probability of default is higher, and, as a result, there is an increase in expected loss. Should we or should we not be notching for that?
We have some sense from the market that it is pricing cumulative and non-cumulative differently. That to me suggest that the market already recognises there is a risk between cumulative and non-cumulative hybrid securities.
EuroWeek: Bill, what do you think about the proposals, particularly the cumulative versus non-cumulative part of it?
Scapell, Cohen & Steers: I don't give much value to the cumulative versus non-cumulative — I look at it all as a certain form of credit risk. Perhaps if the company is going south then I think about it more. But in general we are much more focused on what are the company's incentives to continue to pay, is it at the operating company level, is it at the holding level, what is the business model of the company and so on.
For most companies something that brings them to defer is typically something that is a very significant credit event that could result in Chapter 11 or some other form of restructuring.
So looking at the history, I cannot see a rational basis for the notching based on recovery because there is just not enough data. Perhaps you can put an asterisk on the rating or something like that but I just can't understand how it is worth a full notch.
Stone, Flaherty & Crumrine: The problem is that it is a blunt instrument — a notch is a lot. Is cumulative versus non-cumulative the equivalent of a full rating notch in terms of potential loss from the security? I would argue no. If you were to look at all of the features and think 'Does this meet the threshold to get you to an additional notch or two?' I would be hard pressed to think about what structures you would need to get you there.
Havlicek, Moody's: I would be curious to find out from this group what would be the solution? You've got this other risk which is hard to quantify — maybe a notch is too heavy-handed. But what would be the solution — going back to just notching once and forgetting about the omission risk associated with deferral and settlement?
Abramenko, Sigma: Let's take tier one, which is a little clearer. If you have a tier one security rated three notches below the senior and another two notches below the senior because of deferral differences it makes no sense to me.
There is an internal inconsistency because there is a double counting of risk. I think you need to look at the joint probability of deferral and default. And if you do it that way, what is the real incremental risk from deferral features?
Havlicek, Moody's: On the New Instruments Committee, we are trying to calibrate relative debt-equity characteristics. What seems to us to be more equity-like than not is non-cumulative, or at least something that mimics non-cumulative. So in the discussions with issuers and intermediaries the purpose is to hit that target of non-cumulative with something that's in the middle — meaning it is in between cumulative and non-cumulative. But where do we draw the line?
Having said that, there is something inconsistent about then saying 'Yes we've achieved this basket 'D' treatment but we are just going to notch once for that particular risk'.
Collins, Merrill Lynch: I would prefer to see a more subtle rating agency acknowledgement of differences in deferrability than a full notch downgrade.
Scapell, Cohen & Steers: Maybe it would make some sense — and this is something that S&P does — to add an additional notch only for lower rated issuers. That methodology would talk more to the joint probability of loss.
Schildkraut-Katz, Merrill Lynch: The view of S&P is that there is one notch for subordination and a second for the issuer's ability to defer or suspend payments. They do not differentiate between cumulative and non-cumulative instruments because both deferral and non-payment are treated as a default, even though it may be a feature of the security that an issuer can defer or suspend payments.
Interestingly enough, in certain instruments with mandatory deferral triggers and an ACSM or an APM that requires the issuer to sell securities immediately to pay the mandatorily deferred amounts, issuers can get additional equity benefits from Moody's without increasing the notching from either Moody's or S&P. Even though the trigger is outside the issuer's discretion so there is an increased probability of deferral, investors should still receive their interest payments on a timely basis because the issuer is required to sell securities to make the payment unless there is a market disruption.
Therefore, because the investor's claim should not be impacted, it is important for the rating agencies to separate the equity characteristics and the loss-absorbent features for the issuer from the investor's right and entitlements.
Abramenko, Sigma: You are exactly right. An ACSM forces the issuer to go to market and address the situation for the investor, but not at the expense of the common equity holder. It's a win-win.
Phil Jacoby, Spectrum: I just question the whole concept of ACSM or whatever you want to call it — it is a nice name and sounds cool. But when bad stuff happens, nobody is going to want to buy much of what a bad company has to offer, so where is the liquidity going to come from?
EuroWeek: What does our issuer have to say about the proposals?
Nelson, US Bancorp: We obviously struggle with some of these issues as well. We would prefer not to see the additional notching because if you get to that point is there any real difference between the two non-payment situations? I don't believe there is.
EuroWeek: US corporate issuers have not embraced the hybrid product as enthusiastically as their European counterparts. Why is this?
Nelson, US Bancorp: There are a lot of catalysts that have driven new isuance up over the last 18 months, but if you simplify it, you have the regulatory catalyst, the rating agency catalyst and market dynamics — rates are low, spreads are tight. At the same time, on the investor side, cash is abundantly available.
In the corporate market, two out of three of those catalysts are in full flow: the rating agency changes in January 2005 and the market dynamics.
But it is not a coincidence that the sector that has really led the way here — the financial one — has had all three catalysts pushing it. The desire for regulatory capital has been the constant.
The corporate sector's wait-and-see attitude with respect to the rating agencies and a longer lead time on the tax implications is understandable because they have less incentive to tinker with the capital structure.
At the beginning of the year, at least in my client base, there was a bit of hesitation. People remember the trust preferred market in the mid-1990s, which slowed temporarily as a result of a US Treasury review of those and similar instruments. They were then later re-evaluated by the rating agencies, which ultimately afforded less equity content than initially.
Both events have no doubt contributed to corporate issuers being very thorough in the initial stages of this market to ensure the product attributes are here to stay.
Financial institutions are looking for innovation to get to the most efficient capital base. The corporate sector is looking for more uniformity. Several issuers have even told us they want us to stop innovating. They want uniformity because it will lead to a deeper market, more efficient pricing and fewer investment banker meetings!
Nelson, US Bancorp: Representing the financial sector, I also want to see more standardisation. Maybe that is not feasible in a year like 2006 with so much innovation but hopefully standardisation will happen over time.
EuroWeek: Many market participants have been surprised that more broker-dealers have not issued standardised hybrids, like the life insurance industry with trigger-based structures. Why is this?
Schildkraut-Katz, Merrill Lynch: You have to understand the driver for each industry and then evaluate the appropriate structure. US bank holding companies are regulated by the Federal Reserve and therefore want to issue securities that qualify as regulatory capital first — and then try to maximise the rating agency benefits while balancing the commercial flexibility of each feature.
Insurance holding companies are not regulated so may be more focused on the rating agency treatment, notching and features of the security.
Broker-dealers fall somewhere in between — taking into account SEC regulation and the potential to be regulated as a bank holding company in the future.
They are asking themselves: 'Does it qualify for SEC purposes today? Would it qualify as tier one capital for the Federal Reserve if it ever needs to? Does it achieve the desired benefits from various rating agencies? If they do not need Moody's credit today, rather than put in features that restrict their flexibility, should they build an instrument that could be upgraded in the future if they ever need it? How long would they have the benefit? And would they have the opportunity to extend the maturity and therefore the equity benefits?'
EuroWeek: What has the NAIC scare taught the market?
Price, Merrill Lynch: I think the volatility introduced by the NAIC was exaggerated and this is always the case with a new product.
But what we saw at the time was a refocus and education on the product.
I am sure for the buyers at this roundtable it was an opportunity to go back to the good old days when people looked at subordination and structure, what the call option was worth and the overall viability of the company, rather than the more recent attitude of looking around the stands to see who is buying it and taking your direction from that.
So the NAIC scare reminded us to focus on the fundamentals of the credit, the structures built into these deals and the expected outcome of the investment. That discipline may have got lost in the adolescent stage of the market.
But if you look back to that time [of the NAIC scare], fantastic deals for Lincoln and Swiss Re were done in the midst of the turmoil.
It was a real education about who really understood the securities and who was looking at the momentum of the market place.
Jacoby, Spectrum: The NAIC realised that the hybrid preferred space was going to grow in popularity and they wanted to get involved and they certainly did! There were lots of new structures and round pegs that they tried to fit into their old square holes and it was not working and it's still not working. But at least we have had a short term fix.
Stone, Flaherty & Crumrine: If we are complaining about the rating agency notches being a blunt instrument then the NAIC notches are up to three times worse. As Phil said, it is still not working and we need to get a rational and final resolution. One positive with the NAIC's approach, however, is that there is an appeals process. If an insurance company investor believes the notching is inappropriate for a particular issue — that is, the structural features aren't so onerous as to require another full NAIC notch — it can appeal to the SVO to eliminate the additional notch. That's something the rating agencies might consider as well.
But the other lesson we should take from the NAIC last year is that liquidity in this market can drain out very quickly. For newer participants this was a real eye-opener. It's not just credit risk that you can be exposed to.
Scapell, Cohen & Steers: The experience of the NAIC further highlights the need to know what the other guy is thinking, regardless of how you look at any given feature.
Owning a hybrid is a bit like owning an off-the-run bond. If you owned a high coupon Ford issue over the past couple of years, for instance, you found out what the liquidity in the plain vanilla on-the-runs really meant.
Here you have a situation where it is not just credit risk you are facing but also the risk of how the market is going to perceive this asset class or some feature embedded in it in a trickier environment.
That is, to the extent that hybrids trade on spread to the senior debt, you can have a sort of 'rubber band effect' where if something does occur, credit-wise, you might see a significant impact, not only from the credit weakness but also because of changes in how the structures could be perceived.
EuroWeek: There was robust issuance from Yankee banks in the US market last year — especially in the final quarter after the NAIC storm blew over. Deutsche Bank and Lloyds TSB brought stunning deals. Why have they and others been so attracted to the US markets?
Schildkraut-Katz, Merrill Lynch: The US market offers Yankee banks great relative value. For those that are SEC-registered, the US retail market provides attractive pricing and right now the ability to do very large size.
There are also what we call true perpetuals: institutionally targeted perpetuals without a step-up — typically structured with a non-call period and discrete call structure thereafter. Merrill has been one of the leaders underwriting these transactions.
Price, Merrill Lynch: What is understated, although perhaps not lost on this room, is the QDI effect. On the retail side, it has really opened up this market so that huge sizes can be achieved.
[In 2003, the Jobs and Growth Tax Relief Reconciliation Act allowed qualified dividend income to be treated as net capital gain and hence subject to a maximum tax rate of 15%. QDI can come from domestic or qualified foreign corporations.]
But the strong ratings and stability of these issuers also help, compared to the LBO scares and uncertainty in the corporate sector. The world is awash with dollars at present and the liquidity we are able to get for a Yankee name, for example from London dollar accounts, has helped drive these deals.
The tier one Yankee market was the precursor to hybrids today. So if you add everything together — the different buyer base, how well known these entities are and QDI — you've got strong foundations for a very robust market.
Our ability to standardise issuance across different countries, entities and regulators has also been one of the driving factors.
That standardisation in the tier one market is something some investors would like to see in the hybrid market. But the Yankee tier one market and the $25 par Yankee market remain the first foray into tier one subordinated instruments that a lot of people make.
EuroWeek: Do Yankee issuers need to offer anything special on top of what US issuers have — such as structural enhancements or spread?
Stone, Flaherty & Crumrine: When we look at a Yankee against a similarly rated US bank the answer is yes.
This is because, in general, Yankee banks hold less capital than similarly rated US banks. I also think that as Basel II gets implemented it is going to leave significant room for interpretation by national government entities, whereas we feel pretty comfortable with how the Fed is going to move down the Basel path.
We are less confident about the so-called implicit government support that the market gives to Yankee issuers. In general, we look at the Yankee banks and want to get paid a little more.
Scapell, Cohen & Steers: I agree that we need a little bit more from a foreign issuer of these securities. The local regulators can have different ways of looking at the institutions that might not be quite as robust as what is done in the US. There are different structures when you go abroad and I have questions about the legal documents as well — there is some very peculiar wording in some of the legal documents when you go to Germany and France, for example.
That said, I do really like the market. There are issues and issuers that look really attractive, in part because of the diversification.
Jacoby, Spectrum: We have significant investments in Yankee bank paper. I like the fact that they offer a different twist to what we would get in the US and more portfolio diversification. Yankees offer more of the yield curve. For example, you can buy step-ups in five and 10 years and you can buy discrete calls, which I like a lot because you get great yield and convexity all over again if the call option is not exercised down the road.
We are all yield hogs and the discrete call structure is where you can be well fed.
EuroWeek: Peter, are you a yield hog as well?
Abramenko, Sigma: I am for the reason that all premiums are compressing. However, there is still some way to go until we hit historical tights. The only reason why we are not there already is because of the NAIC scare. Had we not had that setback, we would right now be at the three or four year tights. But we will get there in the first quarter as investors get more and more comfortable with the structures.
EuroWeek: You're very bullish.
Abramenko, Sigma: Well, if you look at the rest of the corporate landscape what has changed since March 2005?
Credit quality has gone up, equity prices have gone up and the reach for yield and a constructive spread environment have combined to drive spread premium compression for hybrid subordinated debt. Everything is pointing in the same direction.
EuroWeek: Do you think European companies will follow Yankee banks and issue hybrids in the US market?
Collins, Merrill Lynch: The higher quality issuers get great execution in Europe but the lower rated credits, at single-A or lower, have a very strong reception in the US. So it's not really by domicile — it's by credit rating.
Schildkraut-Katz, Merrill Lynch: Foreign issuers have to either go for a true private placement or comply with US securities law — including disclosure requirements.
The financial institutions started doing 144A hybrid capital transactions in the 1990s and increasingly are becoming SEC registered so they can access the US retail market.
EuroWeek: Do you expect issuance to fall off in the first half of 2007 as a result of Basel II and the excess capital it will create?
Schildkraut-Katz, Merrill Lynch: No. We will still have refinancing and capital needs. Banks and insurance companies are constantly managing their capital structures and while 2006 was a record year I fully expect 2007 to surpass it with the entrance of additional issuers.
EuroWeek: Is the innovation 90% done?
Schildkraut-Katz, Merrill Lynch: There was a tremendous amount of innovation in 2006 and that means it is a beneficial time for issuers because we can design the structure that meets their specific objectives and views on different features from a commercial flexibility perspective.
With that said, we are starting to see consistency and consensus in certain industries. For instance, with the utilities that have issued deductibles (it really starts from the 'C' basket that US Bancorp issued in December 2005), an instrument that is cumulative at all times with a deferral up to 10 years has become the standard template.
Will there be more innovation? Of course. We need to focus on innovations and as much as issuers want standardisation it is our job to come up with the next best thing.
But it is also our job to appreciate what our issuers' objectives are and not create structures for the sake of structures but to come up with the best solution from both an issuer and investor perspective.
All signs point to another great year with continued refinancing in the financial institution space, debuts in the corporate sector and continued issuance by utilities driven by capital expenditure. With spreads at or near historical tights, conditions are superb so it is a great time to issue.
Price, Merrill Lynch: I am very much looking forward to 2007. We have an unprecedented confluence of events.
Capital securities are being called away from investors, which will decrease their duration and investors have long dated liabilities they need to match off. So there will be huge demand for these types of deals.
Then you have this financing curve that impacts broker-dealers. Lets say I'm a dealer and my financing is Libor flat to plus a nickel. To achieve my investable return, if I was just to buy a 10 year senior corporate bond, I would have to find something between 125bp and 150bp off, depending on whether it is a seven, 10 or 12 year. Then when I look at my Treasury hedge and repo and everything else I'm still not getting positive carry.
So in this environment, with Fed Funds so high and Libor so high and the inverted curve, we have front end surfers. Broker dealers are moving out of senior bond inventory as there is no such thing as positive carry, it's very expensive and it hurts your ROA.
And with credit derivatives being an off-balance sheet transaction they really are much more attractive for dealers.
But then we look at this liquidity provided by all the central banks which have vast amounts of dollars they need to put to work. Of course they looked at the government market, then they looked at the agency market, then the mortgage market and now they are in the corporate market. As they go down the aisle, they are going to get into the hybrid space.
On the negative side, LBO risk could keep the corporate levels of hybrid issuance down a little bit and the weakness of the dollar could finally come home to roost and hit the US economy.
But overall, I am confident that 2007 is set up to be another great year.
Havlicek, Moody's: 2007 is going to be busy. We've already had some enquiries for January issuance.
I've been doing this for a long time and there have been a number of instances when I have said the market cannot innovate further than it has. But it always does and I fully expect innovation to continue in 2007.