Underwriters are predicting another abundant year for hybrid capital for financial institutions, but doubt that volume will outstrip 2005's records. Capacity constraints are expected to cap growth as banks and insurance companies rapidly fill their tier one and tier two baskets. Jo Richards reports.
A backdrop of attractive funding costs, an ever increasing number of instruments available to borrowers and a rush of merger and acquisition activity within the banking and insurance industries drove record hybrid capital issuance in 2005. And while cost of funds is unlikely to remain as conducive in 2006, M&A activity is expected to be an even greater trigger of business.
A robust redemption schedule of capital instruments is also likely to drive a healthy volume of supply. At the same time, economic growth globally, resulting in the expansion of banks' and insurance companies' balance sheets, will need to be backed up by capital issuance. And the simplification and relaxation of regulations in governing bank capital will make the process easier.
However, bankers are not expecting 2006 to be as fruitful as last year.
"We have had three years of record issuance volumes," says Amir Hoveyda, head of EMEA debt capital markets at Merrill Lynch in London "I would not be surprised, therefore, if the market levelled off or reduced a touch in 2006 because of the capacity constraints."
In 2005, new issue volumes for European banks and insurance companies increased for the third consecutive year, topping Eu104.5bn at the end of October and were estimated to reach Eu110bn by year end compared to around Eu87bn in 2004 and Eu83bn in 2003.
Some Eu50bn equivalent of redemptions, an increase of 32% over 2004, underpinned the market but an important driver of new issuance was risk weighted asset (RWA) growth.
"Banks globally saw their balance sheets grow by between 10% and 15%," says Hoveyda. "In addition, insurance companies, life and non-life, have continued to grow premium income, and both of these elements generate capital needs."
Despite occasional bursts of volatility and the backdrop of rising interest rates, financing costs remained attractive and, with the establishment of the non-step market for true perpetuals, borrowers were spoiled for choice by the multiplicity of markets they could access to raise capital.
"Spreads had ground tighter in 2004 and we started the year with most people calling for wider spreads in 2005," says David Marks, co-head of the financial institutions group, public sector DCM and structured finance at JP Morgan in London.
"We had the last breath of the structured rally in January/February and since then we have experienced modest spread widening. However, despite the back-up in rates, it has been an historically very attractive time to raise capital.
"Five years ago you had a limited number of realistic alternatives as to where you could raise capital, now there is a whole gamut of possibilities. 2005 has been a diverse and interesting market in which to operate."
Resilient market, record volume
Market conditions remained mostly favourable throughout the year. As in all debt markets, the downgrade of Ford and General Motors to junk status created uncertainty in the financials sector. Nor was it immune to the inflation-related volatility in the second half of the year or the uncertain tone following the Spitzer enquiry into the US insurance industry and the hurricanes in the US. But after each event, the financials market quickly sprang back into action, displaying hardiness not evident in other sectors.
"The institutional and retail markets have been very resilient to credit shocks," says David Soanes, head of DCM at UBS in London, "especially when one considers the General Motors and Ford crises and the wobble we had in the credit markets from March until May.
During the difficult March/May period, Soanes says that his firm executed some of its best transactions, citing the tier one Lloyds TSB Eu750m non-call 12 year and HBOS £750m non-call 10 deals launched in April.
"Those issues were done in very challenging times," he says. "The fact is that the attractiveness of holding bank capital continues to grow as investors would, generally speaking, rather own a tier one deal rated single-A from a UK clearer than senior debt of a single-A corporate."
New issue volume built to a crescendo in June as borrowers piled in to take advantage of the improving market and to get their deals done before implementation of the Prospective Directive on July 1.
Alongside the top names, such as French financial institution Crédit Logement, rated Aa3/AA- making its debut at the lower tier two level, and A1/A rated Royal Bank of Scotland raising Eu1.25bn of tier one, triple-B borrowers were able to access the market for the first time in 2005.
Privately owned Dutch insurance group Eureko, for example, was able to raise Eu500m of tier one debt during June and see the deal's book three times oversubscribed. Eureko's tier one is rated BBB by Standard & Poor's.
Hybrid capital issuance fell to a low ebb in July and August as borrowers sorted out Prospective Directive documentation issues, creating an unusually pronounced summer lull. Nevertheless, some eye-catching transactions were launched, including two jumbo deals from Japan's Resona and Sumitomo Mitsui Banking Corp.
Resona Bank priced a $1.15bn tier one non-call 10 deal that was more than eight times subscribed and Sumitomo Mitsui a $1.35bn and Eu700m dual tranche upper tier two deal that was seven and five times covered, respectively.
The book for the SMBC transaction, lead managed by Daiwa SMBC Europe, Goldman Sachs, Morgan Stanley and UBS, came in at an incredible $15bn equivalent.
Another highlight during the quiet summer months was an £850m 30 year tier one deal for Bank of America Corp, issued in the name of BAC Capital Trust and led by Bank of America and Royal Bank of Scotland.
The transaction was an important development for the bank capital market — it was the first US trust preferred securities issue in the European markets and the first foreign currency public tier one issue for a US bank holding company.
Under US regulatory guidelines, trust preferred securities are eligible to qualify as tier one capital, subject to a final maturity of at least 30 years from the date of issue.
As coupon step-ups are not permitted in tier one trust preferred securities, the typical format for institutionally targeted trust preferred offerings is a 30 year bullet.
September was the most active month of the year, beating the previous record established in June, and this despite the record tight spread environment.
As in June, the market was available to a broad array of borrowers from Aa3/AA- rated Dutch bank ING with Eu1bn of lower tier two, to triple-B rated Japanese banking group Resona, which returned, this time to tap the dollar and euro markets simultaneously for $1.3bn and Eu800m of upper tier two money. In sub-investment grade territory, Ba2/B rated Russian Industry & Construction Bank was in the market with a $400m lower tier two transaction.
M&A drives supply
Consolidation within the banking and insurance industries was behind a big percentage of institutional bond business last year but it is expected to be an even more important area of growth for the coming year.
Barclays Bank raised the equivalent of £1.3bn of core tier one to fund its acquisition of South African banking group Absa. Other cross-border M&A included Danske Bank with Northern Bank in Northern Ireland and National Irish Bank, Unicredito with HypoVereinsbank and ABN Amro with Banca Antonveneta. The biggest domestic consolidation took place between Commerzbank and Eurohypo to create the second biggest German bank behind Deutsche.
Shortly after gaining approval of its acquisitions, Danske Bank raised Eu700m of tier two 13 year non-call 10 capital and £150m of non-call 12 tier one.
The Unicredito/HVB acquisition drove a two tranche issue by Unicredito in October, which raised the equivalent of Eu1.2bn.
Changes in regulations in various jurisdictions created opportunities for issuance in 2005.
Spain fell into line with its European counterparts by allowing step-up and call structures for the first time, which raised the prospect of more regular tier one issuance from Spanish banks. However, only Banco Pastor and BBVA issued institutional tier one step-ups in 2005, Pastor with a Eu250m perpetual non-call 10 and BBVA with a Eu550m issue, the reason being that most Spanish banks are already above the 15% limit for tier one.
The Bank of Italy has also softened its stance on the issuance of preference shares, creating potential for the expansion of the bank capital market in general and step-up tier one in particular.
The market was re-opened in the summer of 2005 by Banca Popolare di Lodi and Unicredito, the latter issuing a two tranche Eu750m/£300m perpetual non-call 10 year tier one package.
Both tranches were led by JP Morgan and Merrill Lynch, alongside HVB and UBM on the euro tranche and HSBC on the sterling piece.
The issue was heavily oversubscribed, generating a combined book of Eu5bn for the Eu1.2bn financing.
"Unicredito was a very interesting transaction last year," says Merrill's Hoveyda. "We had not seen tier one out of Italy for about five years but the Bank of Italy changed its stance and authorised hybrid tier one to count towards core tier one measure. So far we have seen two deals, the first was for Banca Popolare di Lodi, but the big deal to come out of that relaxation was Unicredito to partially fund the HVB acquisition."
A change in insolvency ratio calculations by the Dutch regulators allowed Rabobank to issue a lower tier two issue in April.
The Eu1bn Aa1/AA+ rated Rabobank 10 year non-call five deal was launched in April by Citigroup, Credit Suisse First Boston and Rabobank. It was the inaugural lower tier two financing by the Dutch bank. It also achieved the tightest pricing — 17bp over Euribor — in the asset class.
Further headroom was created by Moody's, which in February revised its hybrid capital framework to allow certain structural features, such as call options, interest deferral triggers and levels of subordination, to count more highly relative to common equity. This in turn led Moody's to assign more equity credit to the securities that could be built out of these features.
The most important changes were to the treatment of perpetual preferred securities with replacement language and mandatory dividend deferral, which moved from basket 'C' to 'D', and non-cumulative perpetual preferreds with replacement language and optional dividend deferral, which were shifted from basket 'B' to 'C'.
"Moody's revised framework clarified the features required to secure different benefits of equity benefit, which was something they had not quantified in the past," says Merrill's Hoveyda. "That gave rise to Moody's related deals and we saw several transactions in that space, for example Friends Provident did the first basket 'C' transaction and there were a few US insurance companies that took advantage of this clarification in order to execute deals."
Investors love core capital
An important dynamic in 2005 was the use of innovative structures to achieve better equity treatment from Moody's and receive core capital, and for investors finding it difficult to achieve attractive yields elsewhere, the structure proved extremely popular.
"The deals that have made us a huge amount of money are the non-step up hybrid financials in the euro and sterling markets — the Barclays non-call 12, HBOS non-call 10 and Anglo Irish (Lambay Capital) non-call 10," says Andrew Chorlton, senior investment manager at Axa Investment Managers in London.
"These issues opened up a new tier of capital in the sterling market and paid very attractive spreads because they were launched after volatility in the wake of Ford and GM.
"If you are comfortable with these credits, you want to get most subordinated exposure to get bigger returns. Barclays came in June at Gilts plus 175bp and now trades at 137bp over. It is a regulated business and for a Aa3/A+ instrument, you are getting paid as much as you are for some high yield issues."
Barclays had pioneered the structure in November 2004 and repeated the exercise in March 2005 by issuing a non-step-up Eu1.4bn tier one non-call 15 year deal.
The issue pays a coupon of 4.75% to the call date and then switches to a floating rate coupon. As the deal has no step-up or other incentive to call the paper, the UK's FSA allows the structure to be counted as core tier one capital.
HBOS took the concept to the sterling market, issuing £750m of non-call 10 bonds via UBS and Barclays Capital. The issue, the bank's first preference share for eight years and the first non-step issue in the sterling market, was twice oversubscribed and attracted both institutional and retail investors.
Barclays then exported the structure to the US, placing the first true perpetual without a step-up in the dollar institutional market. The $1bn non-call 29.5 year bond was sole led by Barclays Capital.
Barclays followed a week later with a £750m non-call 12 year deal sold to UK investors.
The introduction in the UK of the integrated bank and insurance regulatory framework gave rise to issuance by the insurance subsidiaries of banks who were raising capital to reduce capital support from the bank parent.
The first transaction was for Clerical Medical, which issued a Eu750m upper tier two perpetual non-call 10 transaction in June.
The issue, led by JP Morgan and Merrill Lynch, was an important capital efficiency process for both Clerical Medical and for its HBOS parent. For the insurance company, the transaction qualifies as regulatory capital and is granted equity credit of 100% from Standard & Poor's and 25% from Moody's (basket 'B').
Scottish Widows undertook a similar financing in September, raising £560m of upper tier two non-call 10 capital via Lehman Brothers, Merrill Lynch and Morgan Stanley.
CMS dies a death
The flattening of the yield curves since March 2005 and increasingly leveraged structures reduced the appeal of CMS-linked instruments for raising bank capital
and many of the outstanding deals lost almost a fifth of their value.
"CMS product was aimed at high net worth individuals and the structure was initially supposed to protect investors from rate volatility, yet they have often lost nearly 20% of their value," says JP Morgan's David Marks. "The product got highjacked and what were supposed to be simple structures became ever more complicated and ended with deals like curve steepeners, in which value was heavily front-loaded."
Deutsche Bank kicked off the year with a successful CMS-linked trade, a Eu900m non-call five year tier one deal paying 6% until the call and several banks followed, one of the better deals being for Bank of Ireland. The Eu600m tier one issue, launched in February, briefly breathed new life into the CMS market but, according to Soanes at UBS in London, that was pretty much it. "In March the yield curve started to flatten, everyone was concerned about rising rates and the CMS market got hammered," he says. "Throughout the year, prices of CMS issues have suffered and most deals are now trading well below par."