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ABN Amro: Hybrid capital – drivers and opportunities

21 Jun 2005

ABN AMRO – a market leader in hybrid capital
ABN AMRO is an acknowledged leader as both issuer and lead manager: No.1 for Bank & Insurance perpetual issues since 2000. No.1 for Financial Institutions in 2004.

What gives us the edge?
* Global presence complemented by local intimacy with our clients and the investor community
* An approach to innovation with no "internal silo" mentality (ABS and Derivatives)
* Product cross-over
* We work hard at understanding both sides of the market  

Hybrid capital is cost efficient for issuers and offers yield-hungry investors significant advantages over many more traditional instruments. Now it is extending beyond its primary use in the financial sector and attracting an increasing number of European corporate issuers. As innovative solutions from intermediaries deliver a diverse institutional and retail investor base, there has never been a better time to consider hybrid capital.
Justin May, Global Head Debt Capital Markets ABN AMRO

The financial sector has long faced a dilemma: the need to balance the demands of regulators and credit rating agencies for a strong capital base with shareholders' demands for good returns on equity and lean capitalisation. The Bank for International Settlement's First Capital Accord in 1988 and the clarification on innovative Tier 1 capital in 1998 were milestones in the development, and acceptance by regulators, of hybrid instruments for banks.

Insurers, on the other hand, were initially motivated to use hybrid capital instruments by ratings agency requirements, with new risk-based solvency regulation coming into play as a driver more recently. In the corporate sector, the clarification this year by Moody's of high equity content for hybrids is now providing a strong  incentive corporates to consider this source of funding.

Ultra low-cost capital
Ultimately, though, the headline attraction of hybrid capital today is that it offers great value. For issuers, low interest rates combined with tax efficiency and access to an ever-larger and more diversified investor community mean that hybrid capital has never been cheaper - or easier to raise. 

For investors, it is simply the best combination of yield, duration and credit quality compared to the more traditional choices. In the current low interest rate environment, debt investors have turned to high yield and emerging market assets, and bought first-loss pieces of asset-backed securities (ABS) issues, all in the hunt for yield pick-up. Hybrid capital is an attractive alternative to those assets, not least because, while being subordinated, it is serviced by highly-rated institutions. The subordinated debt default rate is the same as the issuer's senior debt. Furthermore, the fact that hybrid capital issuers are often highly regulated – particularly in the bank sector – makes this asset class even more attractive to investors.

What is hybrid capital?
Hybrid capital is the generic name for financial instruments that incorporate both debt and equity features. These synthetic preference shares are designed to meet regulatory, ratings agency, accounting and tax objectives, making them highly effective for issuers. Advantages include:

* Cost effective - cheaper to issue than equity, reduces Weighted Average Cost of Capital
* More flexible than common stock and mandatory convertibles
* Accepted by financial regulators
* Tax advantages compared to equity issuance
* Equity credit treatment by ratings agencies   

Investing in bank capital securities, which can have long maturities and are sometimes structured as perpetuals, is also a way to get duration as well as yield for investors that typically purchase plain vanilla bank paper such as short-dated floating rate notes.

These advantages on both sides of the market have stimulated further innovation and fuelled current growth. Issuers and their advisers have also harnessed derivatives to create bespoke solutions, such as structured Constant Maturity Swap (CMS)-linked products, to meet the demands of retail investors and lower cost of capital even further. In July 2004 AEGON issued its inaugural T1 transaction. This was the largest ever third party hybrid capital deal with a variable coupon – in this case linked to the Dutch State Loan (DSL) - which anticipates future Solvency II insurance regulations. The dual currency structure adopted made full use of global demand in both USD and EUR and the notes were sold to both retail and institutional investors.

More recently, the compression of spreads during the first half of 2005 has made true perpetuals (as opposed to step-up perpetuals) economically achievable, creating a new pool of capital among institutional investors for these instruments. NORD LB's true perpetual transaction led by ABN AMRO was the first of its kind for a German bank and Landesbank in particular.  The EUR 300 mln (A3) 5.344% perpetual transaction (with a call date after 10 years) was very well received.

The numbers tell the growth story: Nearly EUR 6 bln was issued in January 2005 alone with more than EUR 25 bln in 2005YTD (to June 2005).

In 2004 issuance accelerated in the second half of the year.  If this trend persists, hybrid capital issuance could be set for another record-breaking year in 2005.

Further, with the focus on the impact of future regulation (Basel II, Solvency II, re-insurance regulations, Insurance Groups Directive and Financial Conglomerates Directive, IAS/IFRS changes), hybrid capital is looking more relevant to financial institutions than ever. 

Emergence of a corporate market for hybrid capital in Europe
The significant success of hybrid capital in the financial sector has also led to the recognition by corporations that it is both cheap and useful in their relentless search for shareholder value. The clarification by Moody's, in February this year, that certain hybrid capital structures will receive high equity credit has boosted the still nascent corporate sector in Europe. Although there have been only a few corporate hybrid capital deals here, we are already seeing an increase in interest and activity in this sector as a result of the clarification of rating agency treatment. 

Hybrid Capital Mkt Developments
YoY Comparison by Volume (to 8th June 2005)
All new IssuesUp 217%
Institutional Step-upUp 163%
True Perpetual IssuesUp 155% since inception
Retail Fixed RateUp 255%
Retail Straight CMS (inc. TEC10, DSL, etc)Up 119%
Retail Structured CouponsUp 2344%
Source: ABN Amro

There is a precedent for the growth of the European corporate hybrid capital market. US companies were quick to see the advantages of raising hybrid capital versus their usual funding tools because they tend to have different funding strategies. Many use long-term debt and sophisticated Weighted Average Cost of Capital (WACC) models, against which hybrid capital is an attractive alternative. As a result, the US corporate market has seen a great deal of hybrid capital issuance. In contrast, European corporates often fund themselves at the short end of the curve – say, three-year money – and worry about the leverage implications later. This means that the advantages of hybrid capital have, to date, been less obvious, but we now see this changing. 

While the drivers of hybrid issuance for corporates (as unregulated entities) are less clearly defined it is likely that from a strategic diversification of funding perspective, the interest in corporate hybrid issuance will continue.

Understanding investor needs is key
With the market perfectly primed, anything is possible, but as ever success will depend as much on matching the needs of issuers with the desires of investors as on ideas per se. This is where a hybrid capital structuring house with a global network and local presence has particular strengths to offer. 

We think that a "black box" laboratory approach, however intellectually rigorous, is in danger of missing the point unless a meaningful dialogue with present and potential future investors is also actively cultivated. That is why, as well as regular discussions with individual investors, we regularly canvass both institutional and retail investors in their local markets to understand not only what drives them today, but how they are thinking about the future.

Looking ahead
So what lies ahead for the hybrid capital market? Risk management frameworks employed by both financial and corporate issuers are becoming increasingly sophisticated and there is a growing portfolio of capital solutions. For example, in the insurance sector the advent of risk-based regulations invites both asset side and liability side solutions in order to optimise capital.

In terms of hybrid structures, we expect evolutionary growth in the form of more structured CMS and true perpetuals – and a continuing crossover of ideas and solutions between financial and corporate issuers. Having used reference rates such as the DSL, CMS and French Tec-10, there are likely to be new reference rates in the hybrid market.

We also see scope for programmatic Tier 1 issuance that will permit more responsive issuance and cleaner integration into a more holistic capital management framework.

Volumes of issuance and the interaction with our clients make us  uncompromisingly optimistic about the relevance and usefulness of hybrid capital in the near future. As the buy-side continues to diversify, growth will be fuelled and both sides of the market will benefit.  

Nigel Howells, Steve Sahara, Cees Jan Welkzijn and Tristan Whittingham from the Hybrid Capital Structuring Team and Piers Townsend from Fixed Income Capital Markets also contributed to this article. For more information please contact the Team on (+44 20 7678 2453). 

21 Jun 2005