After a spectacular 2003, managers of debt capital markets financial institution groups watched nervously as their budget targets were revised upwards. But in the end 2004 turned out to be one of the best years yet for financial institution DCM, says Seb Boyd, and investors, issuers and syndicate desks all had an excellent 12 months.
After A year and a half of deleveraging and prefunding, corporate borrowers began 2004 with very little demand for debt.
Yet investors were cash rich and looking for a high yielding product to invest in. Tier one and upper tier two capital, issued by banks and insurance companies, fitted the bill.
?Corporate issuance volumes are 35%-40% down,? says Anthony Faulkner, European head of financial institutions debt capital markets at Credit Suisse First Boston in London, ?and if you look at the credit continuum, corporate paper typically produces the highest volume of high yielding investment grade paper. The two asset classes on either side of that are asset backed on one side, and bank capital ? where you can get the yield from structuring ? on the other side. Demand for those two asset classes has increased.?
But the level of demand for high yielding products could not be satisfied last year and the spread premiums issuers had to pay for deeper levels of subordination were driven tighter.
?Everybody talks about spreads tightening,? Faulkner says; ?absolute tightening, relative tightening between names, and tightening between tiers of capital for the same name. This tightening has led investors to broaden their horizons for yield.?
Concerns that interest rates would rise as the global economy recovered also drove investors to look for instruments that would protect against rate rises. Floating rate notes and bonds with coupons linked to constant maturity swaps (CMS) were particularly popular in 2004, providing cheap funding for banks, league table business for dealers and a measure of protection for investors.
As long as the corporate bond market remains relatively quiet, demand for deeply subordinated products from financial institutions is likely to continue.
?The minute corporate supply picks up it will make it more challenging for bank capital,? says David Soanes, European head of investment grade origination at UBS.
The quest for non-innovative tier one
For structurers and issuers of tier one subordinated debt, there are two sales routes available ? institutional and retail.
Retail investors are less scrupulous about pricing, but the fees for a retail deal are 2% and a UK issuer may well have to pay tax on the dividends.
Institutional investors are eager to buy tier one capital, and issuers want to sell it to them, but it is increasingly difficult to do so.
The main obstacle is institutional investors' reluctance to buy perpetual bonds, the natural form for tier one capital.
It has long been thought that the only way to sell tier one to institutional investors ? many of which need an artificial maturity so that they can match the asset with liabilities ? is to add some kind of incentive for the issuer to call the bonds on a set date.
However, the Basel Committee on Banking Supervision labels most such incentives to call, such as step-up coupons, ?innovative?, and says that banks are only allowed to issue up to 15% of their tier one capital in innovative form.
But the shadow of Basel has not stopped structurers and originators from attempting to get through the chicane and sell tier one to institutions.
One of the most important innovations of the year was a tier one deal for Barclays Bank on November 24, that was sold to institutional investors as a true perpetual preference share.
Bookrunner Barclays Capital raised a book of Eu2.4bn for the Eu1bn deal, opening a new market in the process.
Instead of having a step-up coupon, or artificial maturity, the bond compensated investors for the lack of an incentive to call through a higher spread.
?The rationale in principle is the same as for an innovative deal,? says Geert Vinken, global head of syndicate at Barclays Capital. ?The only thing you have to do as an investor is work out how much you want to be compensated for the lack of a step-up or the lack of an incentive to call.?
The deal was priced at 105bp over mid-swaps, 45bp-50bp wide of where a standard institutional deal would have come.
?The innovation is on the marketing side,? says Amir Hoveyda, head of financial institutions group (FIG) capital markets and financing at Merrill Lynch in London. ?There is nothing new about the structure from a regulatory perspective. The trick is selling a true perpetual instrument to an institutional investor base in a cost-efficient manner. The conversion from fixed to floating achieves this by taking away the interest optionality, making the deal more attractive.?
The market's acceptance of the Barclays deal was confirmed sooner than anyone had predicted when Allied Irish Banks announced within a week of the first deal being priced that it, too, would issue a true perpetual tier one deal marketed to institutions.
The AIB structure also took advantage of the Irish regulator's more relaxed attitude to core tier one by using a UK special purpose vehicle to achieve tax deductibility.
Royal Bank of Scotland ? which had an excellent year of fundraising last year as it paid for its acquisition in August of US bank Charter One ? raised Eu1.25bn in November with a fixed rate true perpetual bond sold to retail investors.
ABN Amro, BNP Paribas, RBS and UBS were bookrunners on the trade, which demonstrated that banks could raise large sizes in the fixed rate retail market.
?One of the reasons that we had a plethora of new structures is because the regulators have been driving it,? says Alan Patterson, head of European financial institution origination at Citigroup. ?The drive towards harmonisation lost a lot of impetus last year, because there was no real consensus.?
European bank regulators have diverged in their interpretation of Basel II. France, Spain, the UK, Ireland, the Netherlands and Denmark have all introduced new rules on capital in the last two years, but none of them agree on what issuance should look like.
Meanwhile, work on Solvency II ? the second EU directive on insurers' solvency ? has been going on since 2001. Something approaching a final draft should be available by the end of the first quarter of this year and market participants should know what the directive will look like.
Some European insurers were already getting ready last year, and 2004 produced a series of new structures.
Allianz was the first insurer to issue a bond that could be classified under Moody's basket ?C' ? treated as 50% debt, 50% equity. Basket ?C' securities must carry a mandatorily deferrable coupon, and the issuer must commit to replace the security if it is called ? it must be permanent in fact, not just in name.
?There was a lot of focus around hybrid bucket ?C',?says Olivier Jalouneix, co-head of European FIG DCM at Dresdner Kleinwort Wasserstein in London, ?but it was very innovative of Allianz to go ahead and do it. They had to be confident that it would work and that the pricing would be attractive versus the dated benchmark. Though few in the markets except Allianz and the bookrunners would have suspected that it would have been priced so tight.?
Allianz's Eu1.5bn perpetual non-call 10 year transaction was priced just 35bp behind its outstanding dated paper. After only two days of roadshowing, bookrunners Dresdner Kleinwort Wasserstein and Merrill Lynch recorded Eu5.8bn of orders from 330 accounts.
?The deal had been fairly well flagged,? says Cormac Hollingsworth, a syndicate official at Dresdner Kleinwort Wasserstein in London. ?But what was surprising was that when we announced it, so many investors came back saying ?Fantastic, we want to buy this trade, we want to be flat or long insurance'.
?There was no price sensitivity. The Allianz trade was what started the race to where we are now [December] with spreads as tight as they are. It was the right time and the right trade and it provided what the market wanted.?
In October, Fortis Bank followed Allianz, becoming the first bank to issue a basket ?C' tier one security. Bookrunners Fortis and UBS pulled in Eu1.2bn-Eu1.25bn of orders for the Eu1bn deal.
The mandatory deferral trigger was a measure of Fortis's tier one ratio.
In November, DZ Bank priced a ?D' basket security, thought to be the first of its kind. Lehman Brothers structured the deal, but DZ Bank was bookrunner. Most of the bonds were sold through DZ bank's retail network at a scanty 25bp pick-up over DZ Bank's outstanding tier one paper.
Third quarter take-off
After a quiet first half, the third quarter of 2004 brought a burst of innovation in the market.
While Fortis was launching its Moody's ?C' basket deal and DZ announcing its basket ?D' issue, Axa announced the first deeply subordinated debt security from an insurer.
Bookrunners ABN Amro, BNP Paribas, HSBC and Merrill Lynch priced the Eu350m deal at 5bp over CMS, well inside price talk.
Rabobank, which had issued tier one in dollars once before ? a $1.75bn deal in November 2003 ? last year brought a three tranche tier one deal, in sterling, US dollars and Australian dollars.
Predictably, all the tranches were convincingly oversubscribed. Rabobank is the only triple-A rated entity that issues tier one, and very little of it has been sold in the public institutional market.
Merrill Lynch and Rabobank were bookrunners, joined by Barclays Capital for the £350m sterling trade and by Credit Suisse First Boston and UBS for the $1.5bn dollar deal. Westpac joined in for the Australian dollar transaction, launched two weeks later in two tranches.
It was the first tier one by a non-Australian issuer in Aussie dollars. There were two tranches, both perpetual ? a floater at 67bp over Bankers' Acceptances and a straight at 67bp over mid-swaps.
?You have tier one that is double-A on both sides, so in a sense it is skiing downhill,? said one banker at the time, ?but at the same time, it was in three currencies and raised a lot of money. The whole thing was well handled and put together. It would have been easy to get it wrong.?
Demand from investors, and the limits on issuance imposed on many of the best known issuers, meant that the market was last year very receptive to deals from new issuers ? small European banks such as Sweden's Länsförsäkringar Bank and Van Lanschot and Friesland Bank of the Netherlands.
Investors were offered Danish tier one as JP Morgan and others brought a series of deals for Danske Bank, Jyske Bank and Nykredit Realkredit.
The Danish regulators had approved the structure previously, but it took until May for parliament to pass the necessary tax bill.
?It was evolutionary rather than revolutionary,? says David Marks, co-head of financial institutions and structured finance at JP Morgan. ?It was Denmark joining the regulatory mainstream with its acceptance of a tax-efficient instrument. It capped a logical application of Basel and EU guidelines by balancing a sensible degree of loss absorption with appropriate investor protection.?
Two of the Japanese megabanks, Mizuho Financial Group and Sumitomo Mitsui Banking Corp, issued lower tier two debt.
Mizuho's Eu750m deal ? thought to be the first Japanese subordinated debt in euros ? was priced at 148bp over Bunds, or 139bp over mid-swaps, in February, alongside a $1.5bn tranche.
Investors showed enthusiasm for the Japanese banking sector and the bond was trading at 88bp over mid-swaps by July, when Sumitomo Mitsui raised Eu1.25bn through Daiwa Securities SMBC, Goldman Sachs and UBS. At 97.5bp over Bunds, the 10 year non-call five paper came at 75bp over mid-swaps after 240 investors placed Eu5bn of orders.
First issue from Lloyd's of London
One of the highlights of the year came in November. More than 300 years after Edward Lloyd first opened his coffee shop near the Tower of London, the unique institution that grew out of it, Lloyd's insurance market, last year accessed the capital markets for the first time.
Citigroup and the Royal Bank of Scotland led a £500m equivalent 20 year lower tier two deal for the Society of Lloyd's.
?The reason for issuing debt is that we don't have any shareholders, so raising equity is not an option,? said Roger Sellek, commercial director of Lloyd's. ?We are left with issuing either insurance-type products or debt to increase our capital resources.
?Over the last year or so we have been reviewing our capital structure ? the funds held by members and the mutual funds held in the centre. The decision was taken to increase the central funds.?
The Permanent Interest Bearing Shares (Pibs) format appeared in January when Barclays Capital used a ?stripped Pibs' structure for a £400m deal for Nationwide Building Society.
It was given a new twist, however, when it was adapted by Standard Life for the first tier one to be issued by a mutual institution.
Barclays Capital, Merrill Lynch and JP Morgan were bookkrunners on the deal.
Standard Life had started off the year in trouble. Bonds and shares issued by insurance companies were selling off, and Standard Life was the worst hit.
As an unlisted mutual company, it uses an unusual financial year ? from November to November.
That meant it was the first of the UK insurers to submit its results using the Financial Services Authority's new methodology for reporting a ?realistic balance sheet'. The FSA and Standard Life disagreed very publicly about the new calculation, which resulted in Standard Life's solvency being cut by half.
The insurer subsequently announced that it would demutualise and raise tier one capital.
?The Standard Life deal had been two years in the making,? says Hoveyda at Merrill Lynch. ?It was the first tier one issue for a European mutual insurer and was also the borrower's first capital markets transaction since it had announced its planned road to demutualisation, providing its first opportunity to address investors directly and explain the background and strategic direction.?
Most insurers trying to issue tier one capital have used a tax efficient innovative structure with an alternative coupon settlement mechanism ? if they ever had to defer paying a coupon, they would sell shares to pay the deferred coupons, meaning that the interest was still deferred for tax purposes.
Standard Life will not even put the idea of demutualisation to its members for a vote until April 2006, so it could not include a mechanism for selling shares in its tier one deal.
Instead, JP Morgan, which acted as structuring adviser on the deal, remembered a clause in European legislation that allowed for subordinated members' accounts.
In a Pibs structure, an issuing vehicle is set up, which becomes a member of the building society, but lacks any voting rights.
The issuer set up two special purpose vehicles, each of which became a member of the insurer by virtue of a subordinated member's agreement.
If demutualisation goes ahead, the issues will be replaced.
?It was an elegant mechanism for a UK mutual insurer to raise tier one,? says Marks at JP Morgan, ?but its very elegance makes it bespoke.?
The most remarkable aspect about the Standard Life deal was the success of its pricing.
The company took advantage of the deal to present itself and its new management to investors on a roadshow, which coincided with the news that no criminal charges would be brought against March & MacLennan ? the insurance broker under investigation by New York's attorney general Eliot Spitzer.
Standard Life's two outstanding bonds rallied by about 15bp during the marketing process.
The issuer was looking for £750m equivalent, and the total book was over £3.3bn ? £1.5bn for the £300m sterling tranche and Eu2.6bn for the Eu260m euro tranche.
Standard Life was not the only UK insurer shoring up its capital last year.
On June 9, Royal & SunAlliance called a meeting of is bondholders at Allen & Overy's office in London, and asked for permission to change the wording in the ?event of default' clauses of its bonds.
The rewording was intended to make the bonds eligible for inclusion as regulatory capital under the new UK regime.
In late July, after a successful consent solicitation managed by Lehman Brothers and Merrill Lynch, RSA decided to issue upper tier two capital.
?RSA was a very significant transaction because it was a combination of the amendment of the outstanding euro with the inaugural upper tier two issue,? says Hoveyda. ?RSA was the first cross-over credit in the hybrid [capital] sector because it is non-investment grade on one side. It was very much a comeback story.?
As a cross-over credit between investment and speculative grade, RSA was priced at 337.5bp over Gilts, which some bankers outside the deal considered cheap. But the deal was well oversubscribed and subsequently tightened.
Meanwhile, another UK insurer, Aviva, won plaudits for its successful dual currency tier one debut.
After first announcing a deal of £750m equivalent in euros and sterling, bookrunners ABN Amro, Barclays Capital, Goldman Sachs and Lehman Brothers increased it to £1bn. There were 120 investors in the £2bn sterling book and over 250 expressed Eu3.2bn of interest in the euro slice.
The sterling tranche underperformed but came back to 118.5bp/117.5bp, outside the 117bp re-offer level.
European retail fills gap
?2004 was the year of constant maturity swaps, which we have developed as a complement to the existing fixed rate market for euros,? says Spiro Pappas, global head of financial institution and public sector debt capital markets at ABN Amro. ?We demonstrated with RBS that that market is still open, but we have provided an alternative route and an opportunity for a broader range of investors to participate in this market.?
Although there were many new structures and new names, the major battleground for the Euromarket FIG DCM houses last year was retail.
?2004 was the year of the CMS retail perpetual and those banks with real retail distribution capability were able to leverage their way into deals,? says Soanes at UBS, ?even if they are not perceived as structuring houses. So the challenge for banks which are solely structuring advisers and have no retail distribution was to hang on in there.?
In 2003, Asian retail investors discovered the yields available on tier one debt and started a feeding frenzy as banks rushed to sell to them and ?fast money' trading accounts piled into the deals, looking for a quick profit. When the US Treasury market sold off in July, that market disappeared.
In 2004, financial institution issuers looked to European retail investors to fill that gap.
?The Asian retail market had died a sad death in late 2003,? says Patterson at Citigroup. ?The growth of the European retail opportunity is something that developed gradually during 2004 to something that is now a durable market.
?The pricing in European retail is a bit more realistic. The retail market in Asia was looking for a short term gain. And the sustained Treasury rally throughout 2003 permitted that, but when Treasuries backed up, the market was just not attractive. The European market is more of a yield driven market than a price driven market.
?The search has therefore been for a structure for coupons that appeals.?
Axa was one of the first movers, when it issued a series of CMS-linked deals in late 2003 and early 2004. The first Axa deal in November 2003 was led by BNP Paribas.
?In Autumn 2003, having watched the fixed rate perpetual market suffer when interest rates in the US market went up, we spent a lot of time thinking about a new product for the retail perpetual market,? says Anthony Fane, global co-head of FIG DCM at BNP Paribas.
?If you want to buy a floating rate instrument as a hedge against rising interest rates then you should also try to capture the widening of swap spreads that normally accompanies rising rates. Therefore, a variable rate of interest in a coupon fixed over the 10 year swap spread seemed more logical and also gave reasonable coupons as opposed to Euribor.?
The structure is not without difficulties, though. ?CMS has traditionally, over many years, been sold as a low volatility asset ? rather like a high coupon floater,? says Soanes. ?Because it has got limited interest rate risk it is seen by retail as a ?par' product. Once credit risk and curve steepness risk are added, though, it changes it spots.?
The worry is that the product might not be right for investors, and that the level of risk is not priced in.
?CMS-linked product is perfect in a rising rate environment and straight fixed rate is perfect in a falling rate environment,? says Faulkner at CSFB in London.
When rates are not clearly moving in either direction, the attraction of both products is less certain.
CMS-linked trades first became popular in the medium term note market, and in high yielding currencies such as the Polish zloty, but by the beginning of the summer, CMS ? or similar concepts such as Dutch State Loans ? was showing up in the coupon structures for large tier one deals.
?If you have a positively sloped yield curve and an expectation of rising rates,? says Marks at JP Morgan, ?then CMS has got to be a favoured product.?
Banco Popular chose the structure when it issued a Eu250m perpetual deal at 12.5bp over 10 year CMS, sold by lead managers ABN Amro and Dresdner Kleinwort Wasserstein (see page 73 for more details).
In July, Aegon priced a perpetual deal which had a euro tranche priced over Dutch State Loans and a dollar note priced over 10 year dollar CMS.
ABN Amro was bookrunner, with BNP Paribas and Citigroup as joint books on the dollar piece.
ABN Amro later reopened both tranches to make the deal the largest variable rate issue yet, at Eu950m.
?Everybody was busy saying the dollar market was dead and buried,? says Pappas, ?but we proved that that was not the case and that for the right deal, priced correctly and executed correctly, the market is still there.?
The market was more than usually quiet over the summer, but roared back to life in September. The first full week of September produced Eu11bn of financial institution bond issues, setting the scene for a profitable second half for investment banks, as issuers plundered the CMS-linked market, disbursing the generous 2% standard fee for retail transactions.
The CMS structure really came in to its own in September, when Anglo Irish Bank and Nordea were able to sell Eu1.1bn of paper between them.
Having announced a Eu200m deal, Nordea raised Eu500m of tier one capital at 5bp over CMS with an 8% fixed rate coupon for the first year. ABN Amro, BNP Paribas, JP Morgan and Merrill Lynch built a Eu750m book.
?Nordea was a clear turning point for the market,? says Ryan O'Grady, a syndicate director at JP Morgan in London. ?If there was one deal that brought the CMS structure into the mainstream, this was it.?
The level of demand seemed to remain high as Anglo Irish raised Eu600m of tax deductible CMS-linked tier one through bookrunners ABN Amro and Merrill Lynch.
However, a subsequent deal from Santander Central Hispano became bogged down, and rather than issuing the Eu500m the market was expecting, bookrunners BNP Paribas, Citigroup, JP Morgan and Merrill Lynch priced only Eu300m, later adding a fixed rate tranche.
The first directly issued Spanish tier one had been Banco Popular's trade, launched in 2003 by Credit Suisse First Boston, Dresdner Kleinwort Wasserstein and JP Morgan, before the details of the new legislation had been clarified.
Banco Popular issued a second deal this year. With 12 banks bidding, Banco Popular made it clear that it would be looking for a firm bid. Given the amount of time it normally takes to document a tier one deal, this was thought to mean that the successful bank would have to carry the risk of the trade on its books until it could be priced and sold.
In the event, ABN Amro and Dresdner Kleinwort Wasserstein astonished the market ? and infuriated rivals ? by bringing the trade in days, using the prospectus from the previous deal and a cover letter.
As Spanish tier one is sold to retail and retail intermediaries, the banks that had missed out on the mandate were outraged, saying that the documentation provided before the sale was inadequate, bearing in mind the complex nature of the security and the legal uncertainties surrounding the trade.
The Popular deal was priced before the full law had become available, but by the time Santander's transaction came out, the market knew what it was dealing with.
Spanish holders of the debt must pay withholding tax, as must residents in jurisdictions labelled tax havens. Other investors are exempt, but to show that they are tax residents of an exempt jurisdiction, investors must give information to the Spanish tax authorities.
One of the reasons the deal was not as successful as had been expected ? apart from indigestion caused by the Anglo Irish trade ? was that it was delayed because of wrangles with the clearing houses over which institution would bear responsibility for collecting investors' names.
The problems encountered by the Santander deal have been the focus of discussions about the sustainability of the CMS-linked product ever since.
?CMS has opened up the market to weaker credits,? says one head of FIG DCM, ?but I wonder how long the product will remain after the first coupon rolls off. Every investor would have been better off buying fixed rate last year, as it turns out.
?We have to be very careful in this business about sustainability, and if the retail networks think we have abused them, they will turn the tap off.?
The market should last, says Alan Patterson at Citigroup, but it may not be able to absorb the volumes that were being pumped out in the third quarter of last year.
?It is a product of private banking intermediaries looking for a product that would be defensive,? he says. ?You have to have a more aggressive view on rates to look at these on a fixed rate basis. We will see more CMS, but perhaps with a more realistic view of what size can be done. With fixed rate deals you can achieve the size, but it is slightly more expensive. Nordea and Anglo Irish are the only two CMS deals that have delivered volume.?
But Patterson warns that the market does not cope well with having several deals to consider at one time. ?Investors gravitate towards the cheaper coupon,? he says. ?All the fixed rate deals that have been in the market have had a clear run. The CMS ones have not. Also, you don't get a single investor that can drive a CMS transaction ? people aggregate orders, rather than coming in straight away. They are harder deals to read. You have to be more patient and there is a balancing act in terms of keeping the faith ? you have to wait for them to build and at the same time to maintain the market's confidence that the deal will work.
?You do not control the distribution channels like you do in the institutional market.?
In early December, Banque Fédérative du Crédit Mutuel priced a CMS-linked deal through BNP Paribas, HSBC and Lehman Brothers. At Eu700m, it was the largest CMS-linked tranche priced up to that date, and appeared to demonstrate that investors had not tired of the product yet.
?Perpetual capital will be the main game again in 2005 and you will see a further muddying of the waters between retail and institutional,? says Pappas at ABN Amro. ?The CMS market is not over ? it will mutate. There is appetite for the so-called structured perpetual product.?
In December, Deutsche Bank priced a Eu250m fixed/collared floating rate hybrid deal for Axa.
The perpetual non-call five year deal pays 6% until the first call date, thereafter switching to a rate of 10 year CMS minus two year CMS, multiplied by four, with a maximum of 10% and a minimum of 3.75%.
Some FIG investment bankers are cautious about introducing a coupon structure that retail investors might not be able to understand properly.
?When we started off it was CMS plus a spread,? says David Marks at JP Morgan. ?Once you put a cap on it, it gets more complicated. Once you put a floor on it, it gets more complicated, and once it is fixed then floating, capped and floored, it goes from being an intelligible retail product to one that only sophisticated high net worth investors can understand.?
Another originator had already expressed reservations before the Axa deal was mooted.
?If they were buying these deals at the right price we wouldn't be selling them,? says the banker. ?The product reminds me of the old collared FRNs, which you would sell at Libor plus 50bp with a floor of 3% and a maximum of 8%, for example. When rates went up they were all sold down to 95.00 and retail investors got hammered.?