Hybrid Capital Markets Roundtable 2008: Part 3
IFR: That’s fine assuming people use this PCDS market as a hedging tool. The danger, of course, is that it will become a market in its own right and overtake the cash sector, and then things will trade purely technically.
David Soanes: I am surprised anyone is interested in setting up a new CDS market, considering how the tail has been wagging the dog.
What is potentially more interesting is some of the pricing we have seen. Some Triple A UK RMBS traded yesterday at 190bp over swaps for two-years, which is a bizarre price, considering where the Tier 1 from the same issuer is going to be, which is, let’s say 400bp. You have secured debt on an LTV of whatever and you are absolutely certain of your principal back, assuming there’s not some complete catastrophe. I just don’t quite understand the difference between the hybrid market and the investors which are in there and this massive pool of capital which seems not to be being looked at at all. This huge issuance market appears not to be being considered by people who I would have thought would be looking for anomalies. If you want to look for anomalies, it’s not in whether someone’s got a must-pay coupon anymore, frankly, it’s in the fact that the underlying collateral is trading at the equivalent of 50%. That, to me, is much more of a relevant issue than the hybrid market right now, which I think has actually traded pretty well.
Raphael Robelin: You could probably make a similar observation for where senior debt and Lower Tier 2 debt is currently trading versus Tier 1. The repricing there has arguably been much more brutal for what is, in effect, a pretty safe investment in most cases.
David Soanes: But the difference is that there’s a supply-side problem in senior debt. You feel there could be a weight of supply. There’s no supply-side problem in RMBS: it is finished for the time being.
Laurent Frings: I think it depends whether you are looking at forced selling as a supply side, in which case it is actually the other way around!
David Soanes: But my point is that I would much rather you were buying mortgage-backed securities right now than anything else.
Jean Dessain: What do we think is missing in order to create this market for CDS?
Raphael Robelin: There needs to be a collegiate willingness to make it work. There are definitely weaknesses in the product, for example, with PCDS, my understanding is things like extension risk aren’t covered. For European investors, obviously the extension risk is a big issue. If you have a bond that’s not called, arguably the cash bond is probably going to fall by anywhere between five and 20 points and the PCDS is not going to be triggered. So, you are being imperfectly protected by the instrument, which I think is a weakness. If we had a product that was triggered if there was an extension and a particular bond was not called, it would definitely go some way towards helping. Then there’s also a need for market-makers to provide liquidity and transparency, and, again, in Europe, I don’t think this willingness has been there.
IFR: Do you mean “imperfectly protected” as in “not protected”?
Raphael Robelin: Well, you are still protected against coupon deferral and default, but you are not being protected against extension risk, which arguably is 50% of the problem in the European hybrid market.
David Soanes: Of the step-up hybrids that come up for call this year, what percentage will be called on uneconomic terms for the issuer and how many of those deals will not be called? What do people really think about how many deals will be called, when they clearly shouldn’t be from an economic perspective?
Raphael Robelin: I saw a survey on that as recently as last week and, certainly on the investors’ side, in excess of 99% expected every single bond to be called.
David Soanes: So those investors would be prepared to accept PCDS without the extension risk element being taken off the table.
Raphael Robelin: If people always behaved logically, then you would have a point. Unfortunately, that tends not to be the case.
Laurent Frings: Again, it depends what instruments you are looking at. If you are looking at non-steps, the perception would be very different.
David Saones: I was talking about step-ups, which are the majority.
Laurent Frings: I absolutely agree that investors will expect 99% of those issues to be called, except if we are in a very stressed situation, and I can’t see that changing all the way from Lower Tier 2 to step Tier 1.
Raphael Robelin: Non-steps are actually a very interesting subject, because my understanding is that there is a broad divergence of opinion amongst issuers, amongst structurers and amongst investors as to whether they will be called or not, and I find it interesting that in the euro market investors are unsure and are pricing at a low premium against that particular risk. I think that most sterling investors are still convinced that every single non-step bond will be called.
It is interesting that it tends to be so geographically different. Obviously, we will have some data points in about three and a half years’ time when the first non-steps come to maturity, and that is going to be very interesting.
Jean Dessain: And you could have regional differences, given the roles of the various regulators. Some might allow redemption at call, while others might ask financial institutions not to call.
Jennifer Moreland: It still seems to be very likely that most of these instruments will be called, despite it not being economic to do so, and that has been suggested as a criticism for permanence in hybrids and that they are therefore not providing the loss absorption they should be. I would disagree with that view, however, because in making the decision to call something, even if it wasn’t economic, you have to take into account the moral responsibility, future access to the market and the desire to keep a very important investor base happy, and that is a different analysis in a truly stressed situation. In a truly stressed situation it is a lot more likely that you might actually see one of these extending and that is a different decision and that is exactly when you want the hybrid to be providing that loss absorption. Hybrids are fine as they are and we don’t need to enhance them.
Steve Sahara: It is also economic to call the securities, even if a security-to-security refinancing is at a higher rate, given the overall economic cost if your whole curve is going gap up because you have blown the trust of the market.
Raphael Robelin: For most issuers, it arguably doesn’t make a big difference to their overall cost of capital anyway, but I certainly agree that a distinction ought to be made by the market between when you are going to call it at a wide level primarily just because of market movements and when it is your own spreads that are trading at very distressed levels because of idiosyncratic credit issues. If you are an IKB or a Northern Rock, I think it would be pretty shocking to see them call –– certainly their non-step bonds –– and the market would probably not expect them to do so.
Jean Dessain: But in the Double A environment, I wonder which institution would dare not call a step-up.
Raphael Robelin: Arguably we are seeing data points, certainly in the Lower Tier 2 space, where in a lot of cases it is uneconomic for them to be called if you look at the deals in isolation: but they are all still being called.
David Soanes: One of the issues with this decision is: who is going to make it? Somebody sitting in an ivory tower could take a look at a transaction and think: “We call it at this price and we have to refinance it here? Well, we are not doing that!” So, who is the person making the decision? I don’t think some people higher up on the boards of directors and in the CEO’s office really absolutely understand the implications this would have on the marketplace or, more broadly, what is actually going on in financial markets right now.
Raphael Robelin: But as an investor, that should probably be included in your credit analysis. When you see an institution that wants to a bring a hybrid, be it a corporate or a financial, typically you are going to see the CFO and the treasurer, and you always want to look them in the eyes and ask them whether they are going to call it, how they see this instrument and who is going to take the decision. Now, you believe them or you don’t, but if at a financial institution the treasurer didn’t have at least some power to influence that particular decision and didn’t get input from the structuring team, from the people in syndicate and so on, that would, in my mind, be an institution that isn’t managed very efficiently.
IFR: Is it therefore purely a lack of communication, with some people being badly briefed?
Jean Dessain: I think people are aware of the importance of calling these kinds of bonds. I think they perfectly understand what’s behind it.
Raphael Robelin: And that’s even more true in today’s environment, where having access to capital and to liquidity is so paramount to your business. That’s why, again, I think instinctively as an investor you are always more comfortable with financials than with corporates, because I think financials’ access to the market, access to liquidity and understanding the market is part of their day-to-day business. With corporates I think there’s more risk and fewer data points to make you feel comfortable as an investor that they will always do the right thing.
David Soanes: So, on that basis, everyone in the room thinks that pretty much every single security is going to be called this year and are not going to step?
Raphael Robelin: I am pretty convinced that if one isn’t called, it will have broad implications for the market. The only example I can think of lately was in Japan when UFJ didn’t pay a coupon, and straight away there was a PR exercise from all the Japanese issuers to explain the context and why that was.
David Saones: But that was a faceless bureaucrat making the decision, which is why it was taken.
IFR: But if we just step back 20 years and look at all the perpetuals issued then, they are virtually all still outstanding. So, the reputational risk argument doesn’t necessarily hold water.
Jean Dessain: It could become very digital. If some major financial institutions do not call their bonds, then it could pave the way for many others to follow, but the risk of being the first is dramatic.
Raphael Robelin: Again, it has broad market implications. If an institution makes a point of calling all their bonds it certainly puts them in a much stronger position to tap the market going forward. If an institution decided against calling their bonds, that would have broad implications regarding their ability to raise capital, certainly with the institutional investor base.
Laurent Frings: If BBVA did not call their non-step sterling bond in three and a half years’ time, do you think they would stop their access to the markets? I am not convinced.
Raphael Robelin: It is very instrument specific and it really depends on how it was sold to investors in the first place, and basically we don’t have data points on non-steps. I think different institutions have been communicating different things to investors and different markets seem to be expecting different things as well: it’s going to be very interesting when these bonds come to maturity.
Certainly, in this particular example, I would tend to agree that I wouldn’t expect these bonds to be called. That being said, the extra challenge is that it’s anybody’s guess where the market will be then and, therefore, whether it will make economic sense or not. I think it’s one of the market’s weaknesses that it tends to calculate the likelihood of a bond being called depending on where the spread is trading today. Is there really going to be such a high correlation between today and where the market will be in seven, eight, or nine years’ time? Unless the spread is trading much wider because of idiosyncratic issues with that particular credit, if it is just down to Tier 1 securities trading at very wide spreads right now, I don’t think it necessarily has much bearing on where they will trade at call date.
Alvaro Camara: That’s what has happened to the Thomson deal, isn’t it? Because it has gone through step-up so much.
Raphael Robelin: True, but I think that is a different example, because there you have had true deterioration in the underlying credit profile, which means that, even if the hybrid market is developed, if Thomson doesn’t improve as a credit, its ability to issue another perp when the bond gets called will be impaired.
To be fair, Thomson was probably one of the very few corporates that came to see us and said: “Look, we see this as a permanent feature in our capital structure. If we can’t issue another bond on better economic terms at call date, we are going to leave this outstanding”. So, they were very clear on that in the first place.
Steve Sahara: One thing that occurs to me, listening to everyone around the table, is that it is very useful to have these roundtables, because we can get an exchange across the table and hear other views, especially from the investor side, which is always helpful and usually positive for structurers.
I think the rating agencies have done a good job of trying to take care of the realities of the market and respond to what investors need when they think about equity securities. I think, going back to the CEBS conversation, however, that they [CEBS] don’t seem to have that type of input as directly available to them.
We have talked about the somewhat subtle distinctions between European investors as opposed to their US counterparts, and established that it is a bit more conservative here. People don’t tend to go as far up the curve as often, they are more risk adverse, the charters are sometimes stricter in terms of what they can do and, therefore, when we look at adding more equity features to securities, Europe is probably the more difficult market to do that in.
We also mentioned the distinctions in retail and private bank markets. If you can issue in the US retail sector, it’s a fantastically deep market: Europe doesn’t have the same type of thing for issuers to fall back on, especially not in large size, so meeting the needs of European institutional investors, I think, is critical, and decision-makers, be they CEBS or otherwise, really need to hear from the market.
David Soanes: One word of caution I would add is that of all the people you met when you bought these securities, virtually none of them will be in their jobs when they come up for call.
Raphael Robelin: In some cases, yes. When it is a BBVA five-year deal, you can probably expect the treasurer to still be around in five years’ time: when it is a Barclays with a non-step in 20 years’ time, probably not. The caveat is, I hope I will be retired as well!