IFR: But surely that would just muddy the waters even more?
Steve Sahara: Well, maybe we should quickly get to the answers. And this may well not be the time to rethink a small tier of the capital structure. Perhaps we should look at the asset side of the balance sheet, hedging, managing the risks that the capital is up against, things like that. Maybe we should be looking at where we are with sub-prime and other asset classes, maybe that’s the place to focus our energies.
Jean Dessain: That’s true, but at the same time they [CEBS] have been working for years now. We are just seeing the results of years of work they first started to discuss with each other 10 years ago. We are in the middle of the process, or even further on, and basically, some of the structures that make the product more equity-like, are already used by some financial institutions. Write-down/write-up has been used in France for several years now. So it is not a revolution, it is an evolution.
Steve Sahara: The principal write-down is currently only an accounting entry that does not reduce the investors’ economic claim in liquidation. If the estimated economic recovery value were reduced by a real economic write-off, the investor base would be limited and the cost of hybrid capital would be higher. If we are just going to make capital more expensive, we could also just change the amount of hybrids that are allowed in the capital structure, but leave the structure as is.
Alvaro Camara: Ultimately, that’s what the limits are there for. If there’s a limit to it, why make it more equity-like than it already is? Instead, set up a framework that provides for an insolvency and liquidation procedure for banks and focus on liquidity, which is the main cause of crisis for banks, not the lack of capital.
Jean Dessain: Another question is the role of rating agencies. They are also monitoring capital and the capital constraints, and their point of view is much stricter than that of the regulators. Will they step in? For the time being I don’t have the impression that they are a part of it. They are just watching from the balcony and waiting for the end result, which is a little bit puzzling.
I want them to step into the discussion. I don’t know whether they intend to react to the proposal, but it’s like with IFRS or Basel II, first you have to implement and then you have rating agencies saying, “Okay, but we are not yet ready”. It certainly makes life more difficult.
Raphael Robelin: Annoying regulators isn’t really a risk they can afford to take right now.
IFR: In terms of the timing, we have suggested it is not optimal, but we have also conceded that this is an ongoing discussion that people have been conducting for years. Ultimately, would no timing ever prove to be optimal, as there will always be downturns in the cycle if the conversations go on for that long? What should have happened; should they have taken a raincheck and postponed, added a bit more time, or do you just plough on?
Jennifer Moreland: The market is owed a better answer to the question as to why this cannot be filtered in with the global process more seamlessly. And if that means a delay, I think that makes sense right now.
The global process has started, these meetings are beginning, but whether that can somehow be accelerated in order to match the timing a bit better, I don’t know. It is very political, so the answer is probably no, although there is some merit in having considered the timing of when everything goes live and when it becomes public.
A lot of what has happened in the markets over the past six months has been media driven but the regulators have a responsibility as well to think about the proposals they are making, when they are making them and how. When they went public was really right in the midst of a lot of confusion and a lot of turmoil in the market and work could have even continued without necessarily needing to be in the public domain as much as it was.
IFR: Would have made sense to delay?
Jennifer Moreland: Potentially, yes. There were meetings prior to the public hearings, but it seems that the feedback, at least that that we gave them, was not entirely translated into the proposals. We touched on the same points that we are discussing but, in spite of the meetings with Morgan Stanley and other banks and investors, they still came up with the same proposals.
Jean Dessain: It’s like when you have a book-building exercise; you have momentum and you need to build on that. That there is a transition period which is long enough so that the market has time to condone the process, fine; but stopping a process like this one at a European level, then we would be postponing a solution for years, many years. The momentum is there.
Jennifer Moreland: I definitely agree that it’s moving and it would be very difficult to stop it at this point.
Laurent Frings: It would be good to have bit of clarity going forward. On the Northern Rock prefs, for example, investors bought that instrument and are now seeing losses, either for the right or wrong reasons. That has happened, but we need clarity going forward, because investors will not touch those instruments in future unless they know how things are going to turn out. We need to talk about that and a solution has to be found.
IFR: What impact has Northern Rock had on the wider market? Are there now deeper concerns? Are investors looking at instruments rather more closely than once you were?
Laurent Frings: I think everyone is. Everyone has to go through the structure and understand exactly what the risks are, which is a good development. You don’t want to put too many other layers, regulatory or otherwise, on top of that: you don’t want to close access to distribution. But investors have to make a decision based on all the facts they have, and as long as those facts are clear, they can evaluate the risk. Less complacency around the market is probably a good thing.
Raphael Robelin: The market is going through the ultimate stress test. You have Northern Rock, IKB and a number of other institutions whose hybrid capital securities are trading at very distressed prices right now. Over the next one or two years we will have resolution as to whether the coupons are going to be paid and what is going to happen.
What is pretty clear is that the only way you can probably justify the spreads at which hybrid securities were trading say one or two years ago was just by looking at the historical dataset available and coming to the conclusion that historically there have actually been very, very few coupon deferrals and there have been no real capital losses on financial securities. This is why — in hindsight probably wrongly –- fixed-income investors got comfortable with buying instruments that have equity-like characteristics for fixed-income portfolios. Now we are going through a stress test, and in the Northern Rock, IKB and a few other cases, we are going to see what happens, and that will create an interesting data point to help investors assess the risks around these particular types of securities.
Now, obviously, if the rules change going forward, then to some degree, certainly for the new type of hybrid products that we are going to have, you will have to restart from scratch.
IFR: Are you not just trying to justify having bought at the wrong price? Maybe not you personally, but the investor base as a whole. Ultimately, it is the investors’ fault that these things were so tight.
Raphael Robelin: Yes, there’s certainly an element of that as well but, again, I think that’s also why Moody’s tried to change their methodology on rating banks, because historically they realised that for a given rating there was always far less default in financial institutions, and banks in particular, than there was for corporates.
So, it is pretty clear that one of the appealing features for investors when it comes to financials is the regulated nature of the sector and the fact that many of the players are too big to fail and therefore you expect a certain degree of protection and intervention if indeed they run into trouble. That’s always very, very hard to quantify, but the fact is, historically, it has always happened.
IFR: But that is a fairly dangerous strategy to adopt, isn’t it?
Raphael Robelin: It certainly is.
Sean Richardson: Coming back to the original question, what Northern Rock has done is highlight the difference between legal form equity and other forms of Tier 1 instruments. Obviously, there were different implications with deferral features for these instruments. The pref holders could have got voting rights in the case of deferral or bankruptcy, hence the need for nationalisation, or at least government control.
IFR: There is one sector that we have not really mentioned as yet, and that is the corporate hybrid market. In Europe, we have seen just one issue in the last nine months or so. Is it something we are not going to see for a while?
Raphael Robelin: It certainly has features of a bull-market instrument and obviously one of the reasons a lot of investors bought hybrid securities in the first place was that in a low-yield, low-spread, low-volatility environment, the need to get extra yield in your portfolio is very strong and there is therefore a strong incentive to go and try to start looking at more exotic securities. This typically means either broadening your base and starting looking at, say, emerging market corporates, or possibly crossover types of credits that are on the cusp of investment grade, or looking at more subordinated parts of the capital structure.
Unfortunately for many investors, they decided to take that particular route and obviously they have been punished. In the same way that investors were very complacent on the financial side and have been punished, those who bought corporate hybrids have been punished as well.
Now, you have two problems going forward: (a) if you have been punished, you have been complacent, and the likelihood that you are going to keep on investing in these asset classes is somewhat lower, and (b) you are now getting a lot of spread and attractive investment opportunities in the plain vanilla market, so the incentive to go for the more subordinated part of the capital structure to get the extra yield arguably isn’t really there anymore.
By the same token, I think for high-yield investors who tend to really work very hard on the capital structure and typically always give a lot of importance to the seniority, the covenants and so on, they are not natural investors in hybrid instruments, in particular for high-yield credits.
So my best guess is that, in some sectors, the strong sectors, be it utilities, possibly telecoms, for the better companies with a stable to improving rating, you can probably still issue debt, but for the weak Triple B issuers that are trying to use a hybrid to basically stop their ratings from being downgraded, it is going to be very difficult, in particular if they want to issue in size.
Jennifer Moreland: I would take a slightly contrary view to that. Recognising all the concerns that you have, our view is still that there are enough investors that will buy, albeit at wider spreads. Deals can get done in big size, and if you look at the order-books of many of the (senior) corporate bonds that have come to market recently, there is enough pent-up cash that for the right story at the right yield; there is a price.
From the issuer’s perspective, there have been two problems identified with the corporate hybrid product in recent months, both of which I think are overdone. One of them is that the spread levels make it prohibitively expensive to issue a hybrid product, when the reality is that the rally in rates –- less pronounced in euros than in other currencies, but nonetheless true in euros as well — means that, on a fixed coupon basis, a lot of the hybrid coupon levels that you would look at nowadays aren’t that different than six months ago when a lot of the issuers were planning hybrid issuance.
The second factor is related to S&P’s requirement for the RCC, the Replacement Capital Covenant. Over time, S&P has made it a lot clearer to the market that they are willing to agree that certain carve-outs are acceptable in such a way that they can get the permanence they are looking for out of a corporate hybrid while also giving an issuer the flexibility that gives them more comfort.
So, I think those two big concerns about changes that have happened which make the corporate hybrid product less palatable to issuers are overdone and there are actually mitigating factors associated with them.
Raphael Robelin: I think it just highlights the fact that, for institutional investors, we certainly have issues with these types of instruments. Would we consider buying a hybrid of a strong, say, mid-A issuer in a very stable non-cyclical sector at the right spread? Sure. But would we buy a hybrid issued by a low Triple B credit that has to issue to avoid being downgraded to, say, Double B? No way.
Alvaro Camara: In the short-term, it is clear that there will be no market for a corporate hybrid, at least in the institutional market. If you look at the performance of deals, investors are sitting on huge losses. Issuers have delayed their hybrid plans: it remains a conversation within the banks as part of the acquisition funding, so it’s becoming more strategic as opposed to opportunistic funding.
It may not be that issuers have access today, but there’s certainly enough appetite within the investor community, depending on the price. But the application has also widened and, for example, we are looking at equity-linked, where we can attach call options on a hybrid and then give investors the upside they wouldn’t have with a normal non-dilutive hybrid.
So there’s still a bit of technology that is being transformed from the non-dilutive to the dilutive sector. We still think that it is clearly a have and have-not market, and there is institutional versus retail distribution.
Raphael Robelin: We are seeing even in financials that the convertible bond market is now a route that more and more issuers are considering, including in a hybrid format.
Jean Dessain: We issued in that market at the end of November and even we were surprised by the demand. It went fantastically well, above expectations, and I think you always have to monitor a broad range of markets.
Raphael Robelin: And you did a pref recently as well.
Jean Dessain: And it did perfectly well, despite the fact that in the middle of the book building exercise, we had to face the Credit Suisse (write-down) announcement, which resulted in the withdrawal of all the institutional accounts. So it was a true retail deal, with no institutions involved at all.
Sean Richardson: If you look at 2007 and compare it to 2006 for corporates, we had about 11 issues in 2007 and nine in 2006, but volume was down. We saw a lot more smaller issues coming out of the unrated space.
David Soanes: I think a lot more clients are interested in talking about it now. In the past, the problem was you would have a load of bankers sitting trying desperately to get corporates to issue hybrids or at least share the conversation. Now, it is not quite the other way around, but there are a lot more corporate issuers that are interested in being ready to jump, and whether they pay three, four, five or six hundred, frankly, compared to the price of equity for them, it is worth it.
Raphael Robelin: There is certainly an appeal for investors in non-rated issues in that they do not have to follow some of the rating agencies’ strict and cumbersome guidelines. The rules always seem to be changing at the rating agencies, so it removes that level of uncertainty, but more to the point, I think transactions like voestalpine arguably have more of a fixed-income type structure than those that need to follow the rating agencies –– in particular the incentive to call the bonds at the first maturity date given that the size of the step-up is huge and there’s no non-cumulative payment of coupons as well.
So, for a fixed-income investor, a lot of the features make it a more natural investment than the regulated deals and, again, it also offers an extra layer of flexibility. Hopefully, we (investors) can also have input quite early on in the process to say that certain features would go a long way in making us more comfortable that this is a true fixed-income instrument.
Steve Sahara: I think the step-ups are key, and that goes back to the point about RCCs and other features that the agencies introduced after doing a lot of work in terms of trying to articulate what debt and equity is. Given the spread environment that we are in, to make these securities attractive to investors, you do need to have the higher step-up on the back end, but then that just aggravates the rating agencies and you get regulatory reviews on how permanent the securities are. And RCCs, as we have seen, have not been very popular in a European context, although the alternative is mandatory payment deferral, which is probably going to be less popular with investors these days.
M&A is probably one of the big drivers for future corporate issuance, and spreads don’t matter as much here, terms don’t matter as much as they do to a typical treasurer, because now it is part of a broader strategic initiative where pricing of a particular tranche of securities is less relevant than it would be if it was the only tranche being done.
Raphael Robelin: But it is very clear that, for investors, the two features that are dangerous and really question whether these are debt-like instruments are the extension risk and the risk of missing a coupon payment. Now, obviously, we are going to have some more data points from the likes of Northern Rock and IKB, which are going to be very interesting and hopefully will help investors assess whether it is appropriate to buy these kinds of securities for a fixed-income portfolio or not. But I think that, again, some of these features are very important as well and, as you try and bring new structures to market, the more an issuer and a structurer can demonstrate to the market that the risk of a missed coupon payment or deferral is remote, the easier it will be to sell to an institutional investor base.
Jean Dessain: At the same time, when you look at different issues, I don’t have the impression that the market discriminates in terms of pricing and I take a simple example: the use of ACSM. When you compare two securities from similarly rated institutions, one with ACSM and the other one without, I don’t think that a lot of attention is paid to these kinds of features.
Steve Sahara: At a Double A level I would totally agree. But when you get to the Double B level it may be the difference between doing a deal or not doing a deal.
David Soanes: There’s a lot of focus in the primary process about the particular language on ACSM, et cetera, but by the time the instrument has been in the market for six or eight months, it has been retraded to people who are interested in a momentum trade as much as anything else, and their value analysis doesn’t involve looking at all the features. And then, when something goes wrong, there is a bunch of headless chickens running around saying, “What’s going on?”
I remember when Rabobank had the issue with the NAIC I got a panicked phonecall from a US investor saying, “I’ve just found out that Rabobank isn’t owned by anybody”. That just demonstrates that people have no idea what they are buying half the time and it undermines the care and attention that we are expected to deliver to the investor community. If they don’t know what they are doing, well, frankly, there is not much we can help them with.
Raphael Robelin: It is a valid criticism and I think that a lot of our peers have been guilty of being very complacent and not doing their homework properly, either because of a lack of expertise or just because they felt they didn’t need to. Clearly, the new environment and what is going on is gradually changing that.
Are we still identifying anomalies in the marketplace? For sure, and we certainly intend to take advantage of them. The problem with investment-grade is that defaults and missed coupon payments are few and far between, so even if you do your homework and others don’t, the likelihood of an outcome that is going to make a meaningful difference has not been very high. What is interesting is that we are now in an environment where this particular outcome is a real possibility amongst a number of names in the financial space and we are certainly hopeful that those investors who have done their credit work and who have differentiated between structures will be rewarded as the market comes to the conclusion that this sort of work is necessary.
Steve Sahara: Back in the heady pre-crisis days of the bull market, we could think about derivative markets developing to hedge hybrid risks, although it doesn’t seem like that will happen anytime soon. But I would still be interested in the viewpoints of investors regarding demand for hybrids overall if it was possible to lay off the risk of deferral or extension and buy some type of preferred or hybrid CDS market.
Laurent Frings: It goes back to having a set of common rules for every capital structure and, as we discussed, we are a long way from that. To be able to come with a PCDS framework that is going to be used across the board is going to be very, very difficult if we can’t even agree on what a hybrid is to start with.
Alvaro Camara: And there needs to be a variety of bonds to deliver, otherwise there’s no liquidity in the bonds themselves.
Raphael Robelin: Personally, I think that it would actually help the market if we could have liquid PCDS because we are currently in an environment where, rightly or wrongly, the CDS market is much more liquid than the cash market. At Bluebay we have an investment process where we reassess that investment on an ongoing basis and there are cases where the situation on something that we were very comfortable changes and the problem is that it’s very difficult to exit that particular position the cash market right now in a lot of cases. So, when you can do CDS as well, at least you can protect your investment.
The big problem with hybrid securities is that there’s no underlying CDS market and therefore when you have been unfortunate to make a wrong investment and there is no liquidity in the cash market, you’ve got no exit point. I would have thought that if there was a PCDS market that is liquid in the same way as CDS, you would need less of a premium for the liquidity risk you are taking because you have a way to hedge that particular position in your portfolio if you become less comfortable with it and there’s no liquidity on the cash side.
