Geoff Tarrant: You only have to look at the level of demand incurred by the two largest issues this year, Wienerberger and Rexam, each of which commanded €5bn plus of interest within a very short period of time. These issuers have got investment grade senior ratings and these transactions are attractive due to the spread that is on offer. The Siemens issue last year also illustrated how much demand there is for strong names having seen a total book in the order of €13bn across both of the tranches.
Khalid Krim: If you look back some years to when this market really began to establish itself, we spent a great deal of time communicating with investors in order to educate them on the general structure and explain to them the potential benefits for a non-regulated company of issuing a hybrid. Investors took this on board and subsequently became comfortable with the structure. As a result we now tend to spend more time explaining to investors the specifics of an issue on a case-by-case basis and you can see today investors keen to participate in transactions that would have raised some concerns in the past either because of the nature of the structure or the issuer’s credit rating. One example is hybrids from high-yield issuers. This is something which when you spoke to investors active in the high-yield market was not on their wish list. These investors are used to buying securities which include a covenant package and specific documentation that you do not find in the hybrid structures. We did the Pfleiderer transaction in April. This was a very successful transaction and the first hybrid from a non-investment grade issuer to achieve Basket C with Moody’s and the tightest spread for a high-yield issuer. We have been talking to investors about the structure and the reason for Pfleiderer to access this market segment. The issuer also did a great job in presenting its business and strategy to investors and how the hybrid would fit within its capital structure and financing objectives. Most of the investors, not to say all of them, managed to get comfortable and the deal was massively oversubscribed. Going forward, we also expect to see more and more deals happening in the high-yield arena.
Shazia Azim: What has also been interesting about the composition of the investor-base has been the number of real money accounts that have started participating in a big way. When we first started out there were some canny investors who would say this makes sense as a yield versus risk proposition, while hedge funds would obviously make their own decisions. However, now we see a significant proportion of the order book stemming from real money investors that are buying corporate hybrids as a yield play versus financial hybrids or senior corporate debt. This is a result of the investor education we have touched upon and how they have moved on in terms of the risk/reward proposition. There is also the sense that, as the market has tightened in so much, buying a corporate hybrid is a smart thing to do if you are looking to beat certain indices.
IFR: This is an interesting point, as while we have seen market volatility accelerate in recent weeks, it appears that the strong real money participation that has been highlighted has limited the pace of hybrid spread widening that we have seen in the CDS indices. However, assuming volatility will remain a feature for the foreseeable future, do you think that investors will be able to absorb what is expected to be an increase in supply and how long do you think outstanding spreads can hold in?
Malcolm Cruickshanks: One of the interesting developments this year came from Cemex which has now tapped both dollar and euro markets. Cemex has issued US$3bn worth of hybrids, so there is a significant investor appetite, but it is good from an issuer perspective because you do not necessarily have to go to one market. So you have the different markets competing against each other, which should theoretically underpin the order books for these instruments going forward.
Peter Jurdjevic: While the institutional markets in the US and in Europe are clearly the biggest and deepest hybrid markets, to a certain extent retail investors can act as a hedge for issuers in periods of high volatility as they can also absorb this kind of instrument. Not many European issuers are SEC-registered, but those that are can also consider US retail execution as well.
Franck Robard: Also supportive for investors is the large number of outstanding hybrid corporate issues. This allows them to look at this instrument on the relative value basis, as they would traditionally do for senior bonds, for example. They are also more comfortable with the price of these instruments now, something that they may not have been when the corporate hybrid market took off in Europe in 2005.
Geoff Tarrant: The significant performance of corporate hybrids can in part be attributed to the fact that this was a new product, as the market was just developing. Also, the premiums were too large relative to the risk that investors were taking on, while euro corporate market spreads were materially wider than where comparable deals in the US were trading. So there has been a combination of factors that have come together to help drive that significant outperformance, another being that over the last year or so some structures have become more investor friendly. However, the premium, given that it was a new product, was definitely on the high side. This is similar to what we saw when the FIG market was developing before there was a contraction and Tier 1 spreads began to come in. Part of this occurred due to a higher level of issuance and greater investor familiarity with the product.
Peter Jurdjevic: In the last nine months another factor behind the outperformance is the unfulfilled expectation of M&A activity driving supply.
Khalid Krim: A decrease of hybrid premium versus senior will support new issuance going forward. There is capacity in the market especially when you compare the amounts raised by corporates to financial institutions. I think we will see approximately €30bn Euros of Tier 1 issues in the financial space. At the moment we are talking about €6bn–7bn for corporates and it’s clear that there is more capacity.
IFR: Can this be also attributed to the inclusion of hybrid capital in the benchmark indices?
Malcolm Cruickshanks: It certainly helps. The inclusion in the indices created a bigger need for investors to at least take a view whether to invest or not.
Khalid Krim: Overall I agree it was beneficial but we also have to consider that the rules of the indices are such that that the hybrids have to be rated investment grade to be included in the index. A number of corporate hybrids outstanding do not adhere to this requirement as they are rated below investment grade. Nevertheless, the fact that we see some of these issues included in the indices helps to increase confidence that this is a liquid product and that should maintain this liquidity going forward. This helps to iron out what has been one of the main concerns for European investors.
Malcolm Cruickshanks: At the start of the year, when hybrid capital went into the Merrill Lynch high-yield indices, hybrids all of a sudden represented 8% of volume. In addition, if you consider that hybrids are long-dated, they then made up 13% of the duration of risk in the indices. So again that clearly impacted on demand for the instrument.
IFR: Moving on to a different topic now. Given guidance from Moody's, S&P and Fitch on how to achieve 100% equity credit/content recognition, why has there not been more public issues in this structure?
Peter Jurdjevic: I think it is a combination of the relative newness of the market, combined with the structural features necessary to achieve 100% equity credit. It is one thing for a treasurer to approach the board and get approval to issue a hybrid, which may be perceived as a security that has some element of execution risk by those that are not as familiar with the structure as others. To get that approval is one thing, but to request something that has never been done before – and maybe requires a replacement capital covenant or indeed multiple triggers that may be perceived as increasing execution risk – is completely different. The additional equity credit may not be enough of a benefit to justify going through that process from the issuer's perspective. Nonetheless, as the market develops and people become more comfortable with the securities and with their provisions, it is only a matter of time before one issuer executes publicly a security that receives 100% equity credit.
Khalid Krim: It is also fair to say that there are structures that were used by corporate issuers that already achieved full equity content recognition by rating agencies such as mandatory convertibles and that people tend to refer to this type of structure when they look at “Basket E” or 100% equity instead of the traditional non-dilutive corporate hybrid.
Geoff Tarrant: I think the 100% equity credit structure is going to be very much a fringe product suitable to a small subset of issuers. While we may see a couple of issues done over time, it is a far more difficult product with a lot more risks built into it, which is not going to suit all fixed-income investors. From an issuer point of view, some of the feedback is that the cost/return trade-off does not quite add up at the moment. This may change once there is a greater understanding of the product and some further developments, but I think it is going to be at the fringe for the next year or two.
Shazia Azim: This is a much more popular concept in the US, where more people are looking at it. This is simply because of the legally binding replacement language needed in order to get into basket E – mainly driven by tax reasons. Hence a Basket E-type security which requires legally binding replacement language and mandatory deferral is easier to do in a jurisdiction like the US than to replicate across Europe where there is clearly a bit of a psychological barrier. While they are possible, there is the question of how much effort is required and is the reward commensurate with that effort and the risk that you are taking on board?
Peter Jurdjevic: It’s funny because in the US where issuers have embraced the replacement capital covenant – a necessary ingredient of the high equity content structure – the tax environment makes it difficult to get the 100% equity structure done. Conversely, in Europe where the tax environment is more conducive, issuers are reluctant, at least at this point in time, to execute replacement capital covenants. As the market becomes more unified globally and the RCC is more accepted, I would predict it is going to take off first in Europe.
Franck Robard: There is probably also a limitation on the investor side because, as we mentioned earlier, hybrids with 100% equity recognition increases some of the risks which are taken by investors, such as the extension risk linked to the RCC, or the risk of mandatory coupon deferral related to several triggers which are set at levels close to the current situation. Therefore, the execution risk on that type of structure is higher than for “basket C/D” or “intermediate” hybrids which have been issued up to now.
Malcolm Cruickshanks: Clearly, there is a confluence of factors which may occur and there are other companies which could benefit from that, but in terms of being able to issue publicly, that is a step that may be a little bit more challenging because Glencore, for example, certainly benefited from the fact that its hybrid has been privately placed – and is owned by the partners of Glencore.
Shazia Azim: With corporates there is also a psychological issue in so much as it is harder to convince them of the merits of RCCs, as they don’t want to commit themselves in perpetuity to issuing hybrids. The few RCCs that have been executed, with the exception of Glencore, have been in the financial sector. The financials find it easier to commit to issuing hybrids because it always gets them tax deductible hybrid capital, whereas with corporates it is often difficult to overcome that mental barrier.
Malcolm Cruickshanks: It will be interesting to see the ramifications of S&P's statements on the need for replacement capital covenants and the rest of the world's assumption that it needs to be done. So some corporates will still be using the intentional replacement language which is the model that most European corporates have favoured. I think it will be again another debate that corporates will be having.
Geoff Tarrant: The S&P requirement – that you need a replacement capital covenant to achieve a minimum of 50% equity credit – is probably the biggest change that the market has seen since it started. This is likely to have a significant impact on the market in Europe where investors are used to seeing a 100bp step-up in the language. We should now see a scenario where there are not only step-up securities, but also issuers prepared to enter into RCCs that will also continue to offer a 100bp step-up. However, the latter will likely be in the minority given the reluctance that issuers, particularly those on the continent, have demonstrated when it comes to entering into RCCs. We are going to see an increasing trend of unrated issuers doing IFRS equity deals, which are going to have a materially higher step-up than 100bp, around 500bp for example. We are also going to see rated issuers in Europe look to alternative structures other than step-ups.
Malcolm Cruickshanks: The RCC may be viewed as positive by investors if you want to get to the same 50% equity credit, to have cash accumulation on the instruments. So there is an argument to be made that it should tighten the pricing of the instruments and could be preferred.
IFR: Do you think that the rating agencies wield disproportionate power as they are very often accused of acting like quasi-regulators?
Geoff Tarrant: It is definitely a concern to some clients that there have been changes in the requirements of all the rating agencies since their initial stance on hybrid capital were announced in 2005. The more change that occurs, the more unsettling it becomes for issuers as to what may or may not happen in the future. Where there have been changes grandfathering has been provided which has been a positive. However, it has created a higher degree of uncertainty and we have had some clients who are concerned about what the landscape may look like in 10 years, given the number of changes that we have seen in the past two years since institutional hybrids were issued.
Peter Jurdjevic: In defence of the rating agencies, they have been confronted with a lot of structural innovation in what has been a rapidly evolving market. The agencies themselves are trying to stay on top of this and make sure that the equity credit they afford is supportive of senior ratings and reflective of the equity-like nature of the instrument. If you go back prior to 2005, S&P had always rejected, or been reluctant to endorse, an intention-based replacement language as sufficient for offsetting the effect of the step-up in terms of permanence in part because it was not established that a legally-binding RCC was a viable contractual arrangement. The proliferation of the replacement capital covenant in the US hybrid market caused the agency to revert to its position pre-2005. Nevertheless, it is still disconcerting to investors and issuers that are looking for consistency.
Geoff Tarrant: The change was probably triggered by a watering down of the initial intent-based replacement language that was used in some of the earlier transactions. S&P probably began to question the worth of intention-based language and decided to make the step back to their position pre-2005 stipulating that step-up transactions, by providing a strong incentive to redeem the security on the step-up date, need a replacement capital covenant to cover that position.
Malcolm Cruickshanks: The real difficulty for clients to understand is with the rating agency setting for certain basket E criteria, which is often more onerous than the criteria for common equity.
Khalid Krim: As far as S&P is concerned, there was a second publication on RCCs in June 2007 clarifying the expectations of the agency which was very useful to market participants and corporate issuers in particular. Following these clarifications from S&P some doors are opened and we know that carve outs to the RCC are accepted and should permit us to structure provisions in a way which is acceptable to European clients. I think the key question is, would the European corporates become as comfortable as US corporates in dealing with RCCs? Apart from cultural issues, there are also some practical and legal aspects related to RCCs that need to be cleared first in the European context. US issuers are more advanced, as you were saying, Peter, as they had no choice and had to include RCCs in order to be able to have high equity credit hybrids that are also tax deductible. I think it is a matter of time to see European corporates issuing hybrids with RCCs and we already started to see financial institutions using RCCs in their Tier 1 transactions.
Malcolm Cruickshanks: One of the reasons that the US corporate market has lagged the European corporate market was difficulties in ensuring tax deductibility of coupons. This resulted in those that wanted to issue having to become comfortable with the RCC. I know US corporates again share some similar views to European clients about being slightly uncomfortable with putting in the RCC. But again with the seven utilities that have come to the US, it is almost a contagion across that sector. Perhaps that is something we will see across Europe. Once one comes, perhaps we will see a flow of others.
Geoff Tarrant: We are seeing limited interest from European corporates with regards to replacement capital covenants. So I think this issue depends on how the market responds to the development of new structures that do not require an upfront RCC. If they are embraced by investors then that will probably be the model going forward. However, if not, then you will probably see some people looking more seriously at the RCC.
Click here for Part three of the Roundtable.