Financial institutions are issuing record amounts of hybrid securities. Driven by mergers and acquisitions and changes to regulatory and rating agency frameworks, banks and insurers are increasingly focused on optimising their capital structures. And while the growth of the market has brought a degree of standardisation, new structures are constantly being created.
Regulators, rating agencies, accountants, tax authorities and investors all look at the hybrid instruments issued by banks and insurance companies in their individual ways.
Where an accountant might see debt, a regulator might see equity. A mandatory deferral trigger might be a crucial feature of an instrument for one rating agency, but of little concern to another. And where a tax authority might see a perpetual instrument, an investor might be happy to consider it a 10 year.
But what no interested party could disagree on is that hybrid instruments are becoming an ever more important part of the capital markets.
Issuance across the different tiers of bank capital — tier one, tier two and tier three — and deeply subordinated supply from insurance companies totaled some Eu72bn in 2005, according to figures from Société Générale Corporate & Investment Banking, up from Eu65bn in 2004 and more than double the number for 2002. Supply in 2006 promises to set another record, running well above 2005's figure for the first five months of the year, and with hybrid capital issuance often picking up later in the year.
And market participants are bullish about the future. "Rarely have we seen a product which meets so well the needs of issuers and investors at the same time, providing a
comprehensive range of
instruments from equity to pure debt," says Arnaud Achour, head of debt capital markets origination at Société Générale in London. "That is why we believe this market segment in the long term will go from strength to strength across the different asset classes."
The reasons issuers are raising record amounts of subordinated debt and hybrid capital are several, but the most high profile is M&A activity.
"If you look at some of the recent M&A transactions, they have been drivers of large amounts of capital issuance," says Franck Robard, head of hybrid capital at Société Générale in Paris. "The takeover of HVB by UniCredito, for example, or Banca Nazionale del Lavoro by BNP Paribas in the banking sector. And in the insurance sector there has been the buy-out of minority interests by Allianz and Generali.
"We expect this M&A activity to continue and as hybrids are usually part of the financing packages for such deals it will be a key driver of issuance."
Several other trends also play into the high projected supply levels. "Consolidation is obviously a major factor and is accelerating," says Amir Hoveyda, head of EMEA debt capital markets at Merrill Lynch in London. "We are also seeing further leveraging of capital by companies such as Generali, HBOS and Barclays.
"Meanwhile, organic growth remains strong on the banking side and has picked up strongly on the insurance side. Furthermore, the redemption calendar is very strong, which should support issuance volumes."
The acceptance of new structures has also raised the ceiling on viable potential issuance. Banks that had been approaching or hitting the 15% limit on innovative tier one capital in place in many countries have in the past 18 months been issuing non-step-up deals for which they have extra headroom.
In the insurance sector, companies in the UK have been using, like banks, the lower tier two, upper tier two and tier one structures that are now available to them and which are likely to become an option for continental European insurers under Solvency 2 in the future.
"One of the reasons that the insurance companies have been issuing more hybrid capital is quite simply that they can," says Craig Stewart, managing director, head of insurance investment banking at Barclays Capital in London. "They are taking advantage of having cheaper forms of regulatory capital than equity."
Cost-efficiency is, of course, a key consideration for the banks and insurance companies that are turning to hybrid capital. And the case for the product has become only more compelling since investors have become comfortable with the instruments and driven in spreads across the different tiers of capital.
"The conditions are attractive for issuers," says Pierre Mirat, head of the financial institutions group, Europe, at Société Générale in London. "They can raise substantial amounts of money in an increasingly deep market, where liquidity is very high as a result of the liquidity that investors are willing to put to work in hybrids.
"Investors' appetite has been increasing for three to four years now, as a result of the environment of low interest rates, low credit spreads and the resulting search for yield and performance and duration for ALM purposes from a range of institutions, whether they be insurance asset managers pension funds, or mutual funds. We have also seen the development of credit-intensive fund managers, whether that be hedge funds, CDO managers or specific credit funds, that are looking to use the hybrid segment as a vehicle to offer new risk/return profile products for investors."
The bull run enjoyed by capital securities in recent years went into reverse in May when a rise in fears over inflation spooked equity and fixed income markets, among others. This resulted in sharp spread widening, especially among the most volatile hybrid securities, such as non-step up tier one bank paper, resulting in a reappraisal of the sector.
"Just as we had commented on the low volatility and negative beta of the tier one and insurance subordinated indices, both have returned with a vengeance," said Nigel Myer, a financial institutions analyst at Dresdner Kleinwort Wasserstein in mid-May. "Pretty much as we anticipated, their return is associated with a sharp widening of spreads.
"We think things are finely poised; a recovery is deserved, but not necessarily imminent."
In between Myer's research piece entitled "Who will rid me of this turbulent week?" being published in mid-July, there had been no signs of recovery, nor any deterioration in the situation. But while the primary market was tricky, few market participants expect the reversal to be anything more than a short term phenomenon — even if spreads do not return to the very tight levels of before.
"There has been a bit of a change in sentiment, but I do not think that we have really seen a downturn in the credit cycle," says Hoveyda at Merrill Lynch. "Credit markets are taking their cue from the equity markets on a day to day basis, which is not a natural correlation, but is symptomatic of a sentiment driven market.
Since the hybrid market relies on issuers being able to balance the different opinions of several audiences — the regulators, rating agencies, tax authorities, accountants and investors — it is vulnerable to changes in the views of any one.
In the US, the decision by the National Association of Insurance Commissioners to reclassify several hybrids as common equity changed the rules for insurance companies as investors and changed the supply/demand balance that had prevailed, pushing spreads wider.
Fortunately, no such adverse change has affected the European market, although Standard & Poor's did in late March threaten to upset the applecart when it floated the idea of a new notching policy. However, after taking feedback internally and externally the rating agency let the idea fall by the wayside.
Indeed rather than hinder the development of the hybrid capital market, the rating agencies have helped it.
"They have been a positive factor in persuading issuers to look at these instruments more frequently," says Mirat at Société Générale. "It is clear that Moody's new methodology released in February 2005 prompted the next step in the development of the market by providing issuers with the ability to create structures that generally receive more equity credit.
"And by showing why they believe that these are the right instruments for issuers to use, they have also further validated hybrids in the eyes of investors."
The changes to Moody's tool kit, the methodology it uses to decide on how equity-like are hybrid instruments, made it easier, for example, for issuers to structure hybrids that would be treated as 75% equity and 25% debt by the inclusion of mandatory deferral triggers that automatically stop interest payments if certain credit measures are breached and if the issuer has not addressed this by strengthening its balance sheet.
This structure is favoured by major European insurance companies such as Allianz, Generali and Swiss Re. This is also because such instruments are similarly structured to those that banks use in innovative tier one capital securities, because insurance companies believe that these could be the model for insurance capital instruments under Solvency 2, as they already are in the UK's advanced risk-based capital regime.
Not worth the bother
But while insurance companies have been seeking out the least restrictive ways to get into Moody's D basket, only a couple of European banks have bothered to tailor their hybrids to the new criteria, even if their US counterparts have been keen to do so.
"In a way it is the dog that didn't bark in 2005," says one financial institutions DCM official in London. "When Moody's clarified their guidelines we rubbed our hands together, thinking this would be a catalyst for more bank issuance, because if you can get essentially the same deal away with maybe only a slight pricing premium but more equity credit from Moody's, we should see more issuance. But frankly it never happened.
"What most banks have said is that the mandatory deferral feature takes away some financial flexibility and that for getting an extra 25% extra equity credit on maybe Eu750m of capital it is not worth the bother considering the amount they have outstanding, especially as it would also create an anomalous security within their capital structure."
Outside the pure insurance sector only DZ Bank, the German co-operative, and Fortis, the Benelux bancassurance group, have issued D basket securities.
"Fortis is a good example of the differences between the bank and insurance sectors as to how their financial profile and capitalisation are assessed from the rating agencies' perspective — which is a combination of the bank and insurance methodologies," says Hoveyda at Merrill Lynch. "They therefore get some tangible benefit for higher equity content instruments from the rating agency perspective, which would not be the case if they were a pure bank."
He says that this explains why banks have not structured hybrids targeting 50% or 75% equity credit from Moody's. "For S&P the principle measure of capital is adjusted common equity (ACE), which excludes all forms of non-dilutive hybrids," says Hoveyda, "and Moody's ascribes less of a weighting to leverage and coverage for banks, which are the ratios that are impacted by any equity credit that you get from such hybrids.
"For insurance companies they make much more sense because leverage and coverage are a more important components of ratings by Moody's."
This is only likely to change if, once again, there is a change in rating agency frameworks, this time from S&P. "One of the real blockages in banks targeting rating agency equity credit is S&P's use of adjusted common equity as its key measurement, and the fact that it is a very strict definition of capital," says one hybrids specialist. "The market is yet to discover and is perhaps unlikely to find a hybrid structure that would fulfill the necessary prerequisites for addition to S&P's definition of ACE.
"S&P does also use adjusted total equity (ATE) as a measure and unofficially they have suggested that they have been trying to get their analyst to use ATE at least as much as they use ACE, but there is a tendency for analysts to stick to ACE as the primary measure of capital."
In the absence of such change, many market participants consider the bank hybrid market to have been less dynamic than the insurance sector. "In a way, the established nature of the bank capital securities market as a result of the relatively stable regulations almost predicates against innovation," says one.
But this does not mean that issuers and their bankers cannot push at the boundaries of what is possible in the hybrid market.
"People have been saying for a long time that this business is going to be commoditised," says Vinod Vasan, head of capital products at UBS in London, "but that is not really what we are seeing. That is because these deals are not structured to meet the rating agencies' needs, or the regulators' needs, but a combination of several frameworks.
"These banks and insurance companies are big enough and sophisticated enough to want the best of all worlds."
He acknowledges that for some repeat issuers structures could be alike, but says that it is up to the banks to structure more attractive products. "If you start overlaying the rating agency treatment, accounting outcomes and stamp duty considerations, for example, the structures can get complex, and that is why we are still seeing new structures being created," says Vasan.
An example of this, he says, was the Eu1bn leg of a dual tranche hybrid offering for Swiss Re launched in early May by Dresdner Kleinwort Wasserstein, HSBC and UBS, which also featured a $750m tranche.
The issue was launched through a special purpose vehicle of UBS, Elm BV, and secured on perpetual subordinated loans issued directly by Swiss Re. This enabled Swiss Re to get solo regulatory capital at the parent level, while the securities could be sold to investors without withholding tax, a combination of results that had not been achieved before.
"The euro structure was very much driven by Swiss tax considerations," says Andreas Weber, head of corporate finance at Swiss Re in Zurich. "Using the Elm repackaging vehicle allowed us to issue the subordinated debt directly out of our major operating company and holding company, Swiss Reinsurance Company, and thereby achieve solo capital credit from the local regulator here in Switzerland, the FOPI, yet in a tax efficient manner.
"Generally it is quite difficult for Swiss-based companies to issue directly into the international capital markets because such issues are subject to Swiss withholding tax of 35% on interest payments, and obviously this can be quite a hurdle if you want to distribute paper into the broader capital markets."
The deal also obtained 75% equity credit treatment from Moody's, was designed with Solvency 2 in mind, and was well received by investors.
"This was a classic example of a deal that could have been a commoditised structure," says Vasan, "but you ended up with an incredibly structured solution instead."
Fashioning new structures
While acknowledging the merits of structures such as Swiss Re's, bankers warn against tinkering with structures unnecessarily. "It always strikes me that there is a bit of a competition between some of the biggest issuers to come out with something different," says one hybrids specialist, "something with a little twist that makes their issue different to previous ones.
David Marks, co-head of the financial institutions group at JP Morgan in London, also warns against innovation for innovation's sake. "Everyone aspires to be innovative, but it is not an end in itself," he says. "As Coco Chanel said, we should be creating classics."
He points to the mark-to-market losses suffered on a flurry of CMS-linked structures issued in 2005 that dropped sharply in price when the interest rate outlook changed and which many investors appeared unprepared for.
"What was initially a fundamentally sensible and conservative structure was to an extent hijacked by innovation and became quite a dangerous product for investors," he says. "In the absence of any significant spread widening in financials, for a product to go from par to 80 cents I the dollar is very poor.
"Issuers should learn from that,' he adds. "Their goal should not be to innovate, but to create lasting structures that can meet the conflicting interests of investors, the rating agencies, regulators, accountants and the issuer itself.
"The moral from the US market this year is similar if less extreme."
Weber at Swiss Re says that ultimately the most important judge of what type of capital is being raised is indeed the issuer itself.
"Part of the problem is that the approaches of the rating agencies and the regulators will move on after a certain period of time, and because these are long dated instruments there is always some risk that after you fix the structure today it will at some point become outdated," he says. "This will continue to happen and from that perspective it is important for an issuer not to focus too much on what is on the table today in terms of the various requirements, but also to try to anticipate what future requirements may be, as we did.
"Importantly, an issuer shouldn't structure an instrument that is something he does not feel comfortable with himself."
He cites as an example the hybrid Swiss Re launched in early March. Allianz had sold a similar structure more than two years previously, but the Swiss company felt that the mandatory deferral trigger required by Moody's at that time was too onerous, as it restricted the company's financial flexibility — something that Swiss Re felt, contrary to Moody's, was a key feature of equity. Only after two years and a shift in Moody's position towards Swiss Re's way of thinking did the company proceed.
Only time will tell, however, whether insurers, banks and their advisers have created a little black dress or the emperor's new clothes.