Last weekend the insurance industry regulator withdrew from the punitive approach it has taken since March to the new generation of tax-deductible hybrid capital instruments.
The NAIC — whose Securities Valuation Office regulates how much capital insurance companies must hold against securities they buy — shocked the market by reclassifying swathes of the hybrid market as equivalent to common equity.
That gave them a 30% risk weighting for insurance companies, which was a severe deterrent to buying them.
Now the NAIC has relented, and insurance company investors bombarded Florida Power & Light with orders that made up a third of the $3.5bn-$4bn book.
That is the largest book raised for a hybrid capital deal since the SVO dumbfounded investors and bankers in mid-March with its first reclassifications. Treating tax-deductible hybrids as common equity, rather than preferred stock, defied the market's understanding of these securities' place in the capital structure.
"The hybrid capital market seems to be back in business after almost six months of the NAIC's regulatory vapour lock," said David Hendler, a credit analyst with research firm CreditSights.
After months of long and tedious conference calls with market participants, the NAIC agreed last weekend to adopt a new classification method as a temporary solution.
This is not entirely what market participants wanted — a complete removal of the SVO from the equation was their preference. But as Hans Mikkelsen, credit analyst at Bank of America, put it: "It's the most favourable outcome that could have been hoped for."
Under the new regime, which still has to go through one more approval process in December but is expected to stay in place for about a year, single-A rated hybrids that suffered a reclassification as common equity will be called preferreds again.
Notching system
However, they will be notched down one level on the NAIC rating ladder and given a 1.3% risk weighting, compared with the 0.4% weighting of hybrids that were never classified as common equity.
Triple-B rated hybrids previously deemed common equity will be notched down two levels and will incur a 4.6% weighting.
"Although the new weightings have been effectively picked out of the hat and there was — typically — no explanation from the NAIC as to why one would need a 0.3% weighting and another a 1.3% weighting, it's a lot better than 30%," said one banker. "It should result in the return of insurance investors to the hybrid market in force."
Insurance investor participation jumped from 10% of the book in deals since March to 30% in FPL's offering.
Demand was so strong for the utility's institutional deal that it paid a premium of only 65bp over its senior debt — the tightest subordination premium yet in the US institutional hybrid capital market.
Before the NAIC's intervention in March, issuers paid premiums in the low to mid-70s. These widened more than 40bp when the NAIC queered the pitch, but have tightened again over the past two months.
Flood of hybrid deals
Bankers are predicting that a flood of deals will come to the market before the end of the year.
"There is a positive tailwind here," said Amery Dunn, head of US bond syndicate at Merrill Lynch, which was structuring adviser and bookrunner on FPL's deal, as well as a $350m retail-targeted issue it launched this week.
"The market overall is healthy, and the NAIC has cleared the way for the insurance investors to return to the hybrid market," Dunn said. "This deal is likely to be a catalyst for more hybrid supply, including deals from financial institutions and corporates."
FPL's 60 year non-call 10 institutional deal was led by Merrill Lynch, Bank of America, Credit Suisse, JP Morgan and Lehman Brothers.
The retail tranche, issued a day earlier, was a 60 year non-call five, led by Merrill Lynch, Citigroup, Morgan Stanley, UBS and Wachovia Bank.
FPL timed the market perfectly. It was not only the first issuer to sell an institutional hybrid deal since the NAIC altered its stance, but it also tapped the retail market at its hottest. On the retail deal it paid a 6.6% dividend, at the tight end of its guidance.
In the institutional tranche FPL had originally hoped for a 70bp subordination premium, but with the crowd of insurance investors pushing secondary hybrid spreads tighter, the transaction was priced at 160bp over the 10 year Treasury, the tight end of its 160bp-165bp guidance.
American Express's hybrid, for instance, is trading just 60bp outside its senior paper. At its widest point this year, the gap was 100bp.
Banks to roll tier one
Underwriters are eagerly awaiting a steady stream of high revenue-earning mandates, especially from US banks, where some estimate about $40bn of old tier one deals will hit call dates and need replacing.
Most of those borrowers will probably choose the tax-deductible 'D' basket structure that emerged in the past two months, with issues by JP Morgan, Capital One, US Bancorp and Citigroup's $1.1bn deal last week.
Only a handful of utilities have issued this year, but bankers expect that more will, as well as industrial companies, now that FPL has shown what can be done.
"Issuers will look at the pricing we have achieved on FPL, see that both the retail and institutional markets are robust, and should have the confidence to move forward with their financing plans," said Dunn.
Utilities and other companies are likely to be more concerned about the increasing lack of flexibility inherent in a 'D' basket structure, say some product structurers, and might instead go for 'C' basket structures such as FPL's, and variations on that theme developed by other underwriters.
FPL's deal structure, for instance, "gets symmetrical 50% equity treatment from Moody's and S&P, provides transparency and simplicity for investors, and maintains tremendous commercial flexibility for the issuer," said Jill Schildkraut-Katz, global head of capital products at Merrill Lynch in New York.
"The instrument is cumulative at all times and the issuer has the option to defer for up to 10 years and then pay deferred interest in cash, rather than being forced to stock-settle."
Although only a few industrial companies have issued hybrid capital in the US, many expect the number of offerings to increase as a means of paying for acquisitions, or to finance stock buybacks.
Plenty of capacity
Huge issuance could cause spreads to widen, some say. Others counter that between the US retail, institutional and European hybrids markets, new deals will be easily absorbed.
"You will get supply in some form, but it will not necessarily be a flood of issuance into the US institutional market," said Marc Pomper, a senior credit strategist focusing on hybrid product at Lehman Brothers in New York.
"There is good demand in retail and in overseas markets and in the institutional market you will now see a resurgence of interest from insurance companies as buyers, so I don't think spreads will necessarily widen."
At this point, there does not seem to be any lack of demand. "The supply numbers are all over the place," said one banker in New York. "So far this year there has been terrific demand and the market would be happy to see more going forward."
Some analysts believe a 4.6% risk weighting for a triple-B structure previously called common equity by the NAIC could still deter investors at the margin.
Underwriters argue, however, that if that were the case, the higher risk weighting would simply be reflected in the price the market demands, as with any lower rated security — but that the premium could never be so high that it would be more expensive for the company than issuing stock.
Danielle Robinson
