Hybrid capital issuance to US institutions has been paralysed since the NAIC astonished market participants on March 15 by reclassifying Lehman Brothers' Ecaps structure as equivalent to common equity.
The ruling obliged US insurance companies investing in Ecaps deals to hold much more capital against them than if the securities had retained the expected classification of preferred stock.
Bankers, issuers and investors remain bewildered by the NAIC's thinking, since according to conventional wisdom, Ecaps are less equity-like than other structures which the NAIC classes as preferred shares. The effect has been to virtually wipe out the insurance company bid for hybrid securities.
Swiss Re used a structure for its $750m perpetual non-call 10 year, rated A1/A, that is tax-deductible and gained 75% equity credit from Moody's, but is unlikely to stir the NAIC's suspicions.
However, the tactic of lead managers Bank of America, JP Morgan and UBS was to avoid selling to US insurance companies — and the success of this deal from a top quality issuer proved that a medium-sized hybrid transaction could be done without their help.
Bankers could not deny, though, that pricing was higher than Swiss Re would have paid before the NAIC ruling, and than it did pay on its simultaneous Eu1bn perpetual non-call 10 year euro tranche.
Swiss Re's dollar deal was increased from $500m and priced at the tight end of its guidance of 170bp-175bp over Treasuries, many times oversubscribed. It tightened to around 167bp bid in its first hours of trading.
Desperate to get the high-fee hybrid business back on track, bankers are now parading Swiss Re's deal as evidence transactions can be done, with or without insurance companies.
"We will see more supply," said one global head of syndicate in New York. "There were a lot of borrowers who didn't want to be the first one, so now that we've seen some issuance it will help to reopen the market."
Still, Swiss Re's dollar tranche came about 9bp wider than the euro tranche on a swapped-to-dollar-Libor basis.
"If Swiss Re were not in the middle of acquiring GE's insurance operations and did not need this size, they would probably have opted to do all of it in euros," said one bond origination banker.
Handful of insurers play
Only a handful of insurance companies bought paper, according to market sources, and they put it into their trading accounts rather than general accounts to avoid NAIC scrutiny.
Much of the deal went to money managers and hedge funds also got their share.
Bankers away from the deal praised the lead managers for using the euro tranche as leverage to save Swiss Re a basis point or two on the dollar portion.
The deal has also traded quite steadily in the aftermarket, giving some hope that in spite of having gone to so many trading accounts, it was not hit by flippers.
There was some scepticism about the $4bn book size bandied around by some in the market. Bankers argued that if there had been that much demand, the deal would have tightened on the break more than the 3bp it did.
Many potential issuers are also struggling to reconcile themselves to the fact that issuers such as Swiss Re now have to pay a much bigger spread differential between senior and subordinated debt in dollars than they did before the NAIC action.
The Swiss Re deal was considered by many to have come at a fair, or even slightly aggressive price. At a 170bp spread it was about 85bp-90bp outside where Swiss Re's senior dollar debt would trade.
That is about the differential at which other, slightly lower rated issuers' hybrid and senior securities trade. It is a far cry from the 45bp-65bp spread difference between senior and subordinated paper that top issuers could get before the NAIC action.
"The NAIC issue is still an issue," said one senior syndicate official. "You cannot dismiss it altogether and so we can't say that it no longer has an impact — it definitely does."
Bankers' challenge is to convince potential issuers that while institutional hybrid transactions might end up being smaller, less liquid and more highly priced than before the NAIC's Ecaps decision, the deals' tax-deductibility and the equity treatment they get from the rating agencies still makes them attractive, even at the wider spreads.
"We believe the [institutional] market is there for hybrid capital trades," said one banker. "This NAIC issue continues to be unresolved and you are likely to end up with wider pricing than what you could get pre-NAIC, but we think the market is there and doable."
No one knows how the NAIC will regard the Swiss Re deal. An insurance company investor has to take a deal to the NAIC for review before its Securities Valuation Office can give an opinion.
Swiss Re had tried to get the deal classified before pricing — something the NAIC is willing to do — but after several weeks of waiting it decided to go ahead anyway.
The chances are, however, that Swiss Re's issue will not go the way of Ecaps. In a recent conference call the NAIC indicated that it would not change its classification of some similar Yankee tier one bonds already in the market as preferred stock.
That should presumably mean Swiss Re's deal will be given preferred stock treatment as well.
The deal is a fairly standard structure for a tier one deal issued by a Yankee financial institution. It has optional and mandatory dividend deferral triggers.
If dividends are deferred optionally, they are cumulative but if mandatorily, they are non-cumulative.
If called, the deal must be replaced with capital of equal or higher equity content. If not called at 10 years it changes to a floating rate coupon of 217.8bp over six month Libor.
Intense demand
While the dollar part of Swiss Re's deal grabbed the headlines because of the background in the US market, its Eu1bn perpetual non-call 10 year issue was no mean achievement.
Lead managers Dresdner Kleinwort Wasserstein, HSBC and UBS piled up Eu6bn of orders, and while market participants thought there might have been some loose hands among the investors, the leads claimed allocations were heavily skewed towards real money accounts.
"Investors are keen to get their hands on regulatory capital paper," said one source close to the deal. "Indeed, by buying this kind of paper, investors are able to get to increase their portfolio yields while being shielded from LBO risk."
The interesting feature of the euro tranche was that it was launched through ELM BV, an off-balance-sheet special purpose vehicle. The deal is secured on perpetual subordinated loans issued directly by Swiss Re.
That enabled Swiss Re to get solo regulatory capital at parent level, while the securities could be sold to investors without Swiss withholding tax. It was the first time this had been done on a structure that obtained 75% equity credit from Moody's.
The deal was also structured to take into account forthcoming Solvency II regulatory changes.
While the fair value discussion may not have been as animated as that for the dollar issue, it was still not an obvious call. The leads used several reference points. Munich Re's 2023 non-call 2013 bond, trading at 56bp over swaps, was considered the most similar credit.
Bankers estimated that, taking into account the curve, a new deal with a 2016 call would come in the mid to high 60s. The leads then had to assess the differential between dated and undated securities.
There, Allianz offered a reference point. Its perpetual non-call 2014 bond was trading at 74bp over swaps, while its 2025 non-call 2015 was at 35bp, making the differential around 40bp.
This differential, added to where a new deal would come, led the bookrunners to a spread of around 100bp plus the high single digits.
However, they could not forget that the dollar tranche was set to come wider and they had to be careful not to alienate investors. They therefore released guidance at 115bp area, while the US tranche's Treasury spread was 170bp-175bp.
Seeing the sheer appetite for the deal, however, the leads were quickly able to refine guidance and the Eu1bn perp was priced at 109bp over mid-swaps.
Had the NAIC not decided to upset the US institutional market two months ago, Swiss Re might have been able to get better execution in the dollar market. However, in the present circumstances it chose the euro to raise the larger chunk of its needs.
Danielle Robinson, Hélène Durand
Embarq preps jumbo deal
News of a $4.85bn three part deal from Sprint subsidiary Embarq will liven up what has so far been a quiet beginning for US corporate bond issuance in May.
The SEC registered deal, led by joint bookrunners Bear Stearns, Goldman Sachs and Lehman Brothers, is expected to come to market on Thursday next week after extensive roadshows.
Embarq is being spun off by Sprint Nextel Corp, and will own its local communications operations.
The deal will have seven, 10 and 30 year tranches.
Despite a quiet April for new issuance, the gross high grade corporate bond supply for 2006 to date is about 33% higher than in the same period last year, prompting analysts to predict that total issuance this year will be up 20%.
JP Morgan is expecting total issuance for 2006 in the $700bn range, compared with 2005's total of $588bn.
Although April was typically light on deals, with $46bn after March's $72bn, it was still well ahead of April 2005's $28bn.
Some things do not change, however. So far this year financial institutions have dominated issuance and floating rate notes have once more represented more than 50% of volume.
