The first half of 2006 has been fruitful for financial institutions seeking funds, although true innovation has been low on the agenda. Volumes are well on track to exceed those of 2005, although the pressure on spreads seen in the first half of 2006 should continue. Hélène Durand looks at what is in store for the rest of the year.
Until recently, innovation was a key feature in the bank sector. It needed to be to get deals done. But this year, it's been different. 2006 has been characterised by a lack of any truly innovative structuring as financial institutions hybrid financing is concerned.
Although banks' need for capital continues to be high, the hurdles of previous years have mostly been overcome. "The battlefield has moved for issuers," says Frank Kennedy, head of financial institutions group debt capital markets at UBS.
"The initial focus was on creating tax-deductible instruments which would count as regulatory capital. Then in 2004 and 2005, it was all about getting the right accounting treatment. The major problems have now been solved, it is now all about solving particular issuers' problems."
Barclays Capital's Richard Boath, head of the financial institutions group, agrees. "We haven't seen anything in particular in terms of innovation this year," he says. "We had the CMS tier one in 2004 and non-step preferred last year and the Asian dollar preferred market before that; but there have not been any innovations in terms of capital structuring, it's more about securitisation.
"The only thing where we have seen a little bit of capital structuring is in the insurance space where companies have been working with agencies to achieve 'D' basket treatment, but as such, no new market has been created."
Instead, it has been the other half of the FIG world, the insurance sector, that has been at the centre of attention — not only for innovation but also volumes. As of mid-July, insurance companies had raised Eu9bn equivalent, well on track to exceed the Eu12bn in 2005.
"The main two innovations we have seen were from Fortis and Swiss Re," says Kennedy. "In the case of Swiss Re, the ELM repack vehicle was put in place to solve a Swiss Re regulatory issue: through ELM, Swiss Re could raise solo capital while reaching out to the European and US capital markets on a cost-efficient basis.
"This concept of repack has cropped up again in the case of Northern Rock. In that case, the repack vehicle gave investors exposure to the issuer's sterling preference shares via a Eurobond format, making preference share issuance as efficient for the issuer in sterling as in euros or dollar bearer form," says Kennedy.
In the case of Fortis, the issuer set up a flexible new hybrid financing vehicle for both bank and insurance hybrid issuance, achieving credit ratings notched off the operating companies and saving a one notch rating relative to group-style issuance. "We have had a number of enquiries since the deal from bancassurers who liked the concept," Kennedy says.
Achieving basket 'D' treatment has been key for insurers which are still unsure as to what the final Solvency II regulatory framework will look like and what exactly will be required of them when implementation time comes.
The 'D' basket gives 25% debt treatment and 75% equity treatment to hybrid instruments with characteristics such as perpetual maturity without replacement language but a mandatory deferral.
By the end of 2006 more of these insurance companies will come to market with M&A financing as the driver. Around Eu7bn has already been announced and according to Damien Regent, insurance analyst at UBS, insurers could sell around Eu20bn of euro and sterling denominated debt to institutional investors in 2006, easily beating the Eu12bn of 2005.
"The outlook for supply in the second half remains uncertain though the financing needs in the insurance sector have been well flagged and, coupled with M&A-related activity in the bank sector, will constitute the primary drivers," says Richard Howard, vice president on the financial institutions syndicate desk at JP Morgan.
"The ability of issuers, both US and European, to cost-effectively access the US hybrid market may also impact supply in Europe in the second half."
From the insurance world, Aviva, Axa, Generali, Resolution and Talanx will be raising funds before or around the completion of their planned acquisitions.
Meanwhile, Allianz, Legal & General, Munich Re, Old Mutual, Prudential and Scottish Widows will either be refinancing maturing debt or focusing on making their capital base more efficient.
All this upcoming supply has led to mixed views as to how spreads will hold up in the coming months. "We have already seen spreads in euro denominated tier one and two product begin to grind tighter as supply has diminished and technicals improved," says Howard.
"The outlook for spread tightening in sterling remains perhaps slightly less convincing as issuers continue to monitor that market for opportunities over the summer."
Indeed, supply has hardly stopped in the sterling subordinated sector and has even included newcomers such as Resona Bank, and Wachovia in July. "From a market perspective, I don't see why credit markets should be materially better or worse in the second half of the year," says Boath.
"However, the market is fairly exhausted and with the summer period upon us, investors are not putting their money to work. I do expect to see a flood of issuance in September. Spreads generally have held out and I expect this to continue."
Not all agree, however. As one syndicate manager said: "September is going to be busy anyway, but on top of the usual flow of issuance, there will be quite a lot of acquisition financing. We saw quite a lot of volatility in the first half of the year, and some issuance was pushed back as a result.
"The market is tougher than last year and it won't take much supply to put the jitters back in the market."