Friday, 21 September 2018

The dark arts of corporate hybrids

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Anthony Peters is not a fan of firms issuing subordinated debt.

Driving into the office this morning clarified something I had observed yesterday but not fully appreciated. Put simply, there’s nobody here; the roads were utterly empty. Markets had felt unusually quiet on Monday. Although the pre-Easter week has always seen a slowing of activity, this year it seems much more pronounced. I suppose, had I been looking at the webcam pictures from Verbier, Val d’Isère or Saint Anton, I would have cottoned on to this much earlier.

In the event, phones didn’t ring a lot yesterday and although we did get bits and pieced done, we clearly felt that this will not be the week when we knock the cover off the ball. Thus I wouldn’t want to say that the Dow rallying by 263.65 points or 1.49% told us much other than that there was a bit of month-end and quarter-end index adjustment going on but in terms of hard-core investor sentiment, we learnt nothing as there was, in all probability, not much to learn from it.

There was, nevertheless, plenty of interest in the hybrid issue for Bayer AG who stuck with their customary format of using a callable bullet structure. With a 2⅜% coupon, maturing in 2075 and with a spread of 241bp over Bunds to its first call date in 2022, investors were all over it like a rash. Whether these investors are really aware of what they are dabbling in is another matter entirely.

Subordinated corporate debt is all the rage in a world in need of yield and issuers are not being shy in coming forward in order to oblige. Investors, on the other hand, have been hoovering the stuff up and, not surprisingly, the premium they are being paid in order to take the extra and until recently quite innovative risk has melted away.

Subordinated corporate risk satisfies a string of needs but if fixed income and credit investors think that they are getting the best of the upside, they are sorely mistaken. Corporate sub debt is the ultimate ratings arbitrage. I had, given my background in structured credit, always assumed that the CLO (Collateralised Loan Obligations) was the pinnacle in terms of making a silk purse out of a sow’s ear but I am beginning to see corporate hybrid debt as a much more straightforward example of the dark art.

Joining the circus

Why, one needs to ask one’s self, would a company issue subordinated debt? It didn’t have the capital and reserve restraints which affect banks so who is the winner and why? Look no further than the boardroom. Older readers – that’s the over 45s – will recall the world’s leading corporate names all being in the triple-A, double-A or occasionally in the rather sad and ignominious single-A ratings space. Management was proud of the high quality of its company’s debt. Then, beginning in the mid-1990s, everything became a matter of “shareholder value”. Balance sheets were geared up to the ying-yangs and cash returned to shareholders. It was an age of stock-price above all else. At times, the entire stock looked like a board-approved pump-and-dump circus.

The fashion was for “making the balance sheet more efficient”. Had executive remuneration not been so closely tied to the stock price, a lot of this might not have occurred. Executives couldn’t buy themselves a yacht or a ski chalet from higher debt ratings but they could from a higher stock-price. Ultimately, obviously, there were limits to how far you could reasonably leverage a balance sheet until someone dreamt up the hybrid corporate bond.

The hybrid bond fulfils two principal functions. Firstly, it lets companies borrow without adding further pressure to the senior bond ratings which is good although, of course, the balance sheet is not relieved of debt, thus offering something rather akin to invisible leverage.

Secondly, it gives the borrower cheap equity without diluting the share capital and hence negatively influencing the wealth of those who’s remuneration is linked to share price performance and is expressed by way of stock awards. It is, in many respects, a victimless crime. There is nothing altruistic in corporates issuing subordinated debt.

And yet, investors are tripping over themselves in pursuit of such paper. Early and enthusiastic investors in hybrids made out like bandits but the juice has gone. Furthermore, as in the case of Additional Tier One (AT1) notes, the sub-class has not yet been tested in a prolonged and properly stressed market which renders the pricing process for such paper a bit of a game of pinning the tail on the donkey.

The price of a bond needs to take account of the expected recovery rate in the event of default. I’m not sure anyone has come up with a usable and credible model for this one. Does one insert zero recovery? If so, how should that risk be correctly priced? Certainly 241bp doesn’t cover the bases and that, incidentally, does not even include any meaningful pricing adjustment for the higher liquidity risk of junior sub debt in a stressed market where bids for institutional size will surely once again be scarcer than pink and blue striped unicorns.

The principal risk which should be worrying us is not, when push comes to shove, the one covering default and recovery but the one of mark to market volatility. The higher convexity which the currently low coupons impose on bonds brings with it higher price volatility and hence much higher risk to investment portfolios.

What effect this might have on such matters as the solvency of insurance companies has not, in my opinion, been taken on board. In their race to slaughter market liquidity on the altar of transparency, the regulators are doing just what we feared they were, namely they are preparing to re-fight the last war.

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