Why corporate hybrids are not all they’re dressed up to be
Right now, the future of the corporate hybrid market hangs in the balance. There are signs that it is becoming more institutionalized; the rating agencies’ publication of their equity treatment for different structures gave it a new legitimacy last year. In January 2006, the new corporate hybrids were included in the iBoxx indices, giving them a further boost to be considered a new asset class. The leading investment banks that run their own well-followed bond and credit indices, including some investment banks that are not shareholders in iBoxx, have also added the hybrids. “That means we have to look at them. They are part of our universe,” says Peter Sass, director of DWS.
Raphael Robelin, fund manager at BlueBay Asset Management, calculates that hybrids have an impact on overall bond index performance far beyond their market size, contributing up to 6% of the investment-grade bond index-weighted beta. Owning them might indeed be risky but, he says, “if you decide you don’t like them, not owning them now brings its own risk of relative underperformance”. That helps to keep institutions thinking about the market, but there’s a limit to what index inclusion on its own can achieve.
The asymmetric nature of debt markets counts against volatile instruments. On any single deal, there’s more risk in being long than in being short. Recently, absent any headline news on a credit, these bonds tend to move in step, for example widening together on rumours of new issues. It would be better if there were greater differentiation in day-to-day trading. “It is much more efficient, if I just want to take a high-beta view on the market, to do that through a highly diversified cross-over basket, rather than through one or two hybrids,” says Susan Swindells, portfolio manager at Fischer Francis Trees & Watts.
To sustain itself, the hybrid sector needs more new issues. It remains to be seen whether the deals that originators are cooking up with potential issuers will meet the requirements of an increasingly nervous, sceptical and discerning investor base. Investors believe that last year banks spent most of their energy convincing issuers to do deals, expecting a yield-hungry market to devour them eagerly.
Even that was tough for the banks. For all the obvious cost advantages of hybrids, issuers had reservations and the final decision to go ahead was often taken at a level high above the treasurer who rolls over senior debt. It would typically go above the CFO and the CEO to the board itself. “In our case, it very definitely required board-level approval,” says Joachim Jäckle, vice-president, corporate finance, at Henkel, “and, given that a majority of voting shares are family-held, it also required approval by our shareholders’ committee, our highest decision-making body, akin to the supervisory board.” The German chemicals company was doing something quite groundbreaking, identifying its pension obligations, separating these from its balance sheet and issuing the hybrid to fund them. “Given that there is a long tradition in Germany of internal funding via pension provisions, you might imagine that it was quite a lively discussion,” Jäckle says.
| “If banks try to bring inappropriate issuers and structures, it’s up to us to say ‘no’” Susan Swindells, FFTW |
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Managements and boards have had more prosaic worries. Boards might wonder if hybrids are a little too reminiscent of Enron-style financial engineering. CFOs and treasurers proud of the low volatility on their senior spreads might worry about a high-volatility instrument trading against their name. CEOs might worry about questions from shareholders about dividend policy, given that on some hybrids issuers can only defer coupons if they have also stopped paying dividends to equity investors. Then there are auditors to win around.
The structurer on one deal last year recalls frantic eleventh hour calls to the company when the firm’s auditors revealed their intention to publish a letter stating that the deal would not count as equity. This would have killed it. Only after hours of discussions were the auditors won around to the view that, under the new IFRS accounting rules, the proceeds could be accounted as equity.
Lead times have shortened as more deals appear. A deal that last year might have taken eight months to structure might now be done in two. But even if issuers are won over, from here on in, the primary market might be much tougher for them to access.
At a technical level, investors are concerned about effective final maturities, incentives to call and having cumulative deferral, whether that be optional or mandatory. Much more significantly, they want sound issuers with stable credit outlooks, dependable cashflows, perhaps in a regulated industry and ideally with some form of government ownership. In addition they want to see a compelling rationale for doing a deal. Not being able to issue straight equity because of government ownership gets a big tick in this box. Henkel’s deal to fund its pension obligation was also very well received. But buying back shares to reduce weighted average cost of capital doesn’t go down well. Bond investors dislike the implication that they are being arbitraged.
It sounds as if investors want hybrids from exactly the kind of high-quality credits that have little incentive to issue what they still see as high-cost debt. Utilities are pumping out inflation-linked paper in public deals and private placements at not far above government spreads. Unless they are contemplating big acquisitions, they don’t see anything in the hybrid market for them and some are getting so tired at investment banks’ desperate efforts to persuade them to do deals that they are starting to dismiss it as a bit of a joke. “You want to know the very latest thing?” asks one mischievous treasurer. “We’ve found these amazing instruments that get you 100% equity treatment.” Euromoney falls right into the trap. What are these wonderful things? “They’re called common shares.”
The driver for new issues will be the financing of M&A. German energy utility E.ON has mentioned a potential equity-like component in financing its bid for Spanish company Endesa. Spanish telecoms company Telefónica is being talked about. Other big companies getting caught up in the M&A frenzy might all be candidates to issue.
Bond investors are nervous that many of the acquisitive companies now being talked up as potential hybrid issuers, such as German engineering group Linde and pharmaceutical company Merck, have senior ratings in the BBB range, implying hybrid deals rated below investment grade. “That’s a worrying development for this market,” says one fund manager, “and deals will be very tough to do because of
the covenant protection that investors will require.”
“It is very important now that everyone in this market is disciplined,” says Swindells at FFTW, “and that includes issuers and arranging banks. I would prefer credits with single-A senior ratings making the hybrids solid BBBs. Regulated industries would be good. If an issuer is doing it to fund M&A, what’s their track record in integration, how much M&A are they doing, how does the deal impact the stability of the credit?” She continues. “I would also like to see lead banks with a good track record in the successful deals. And if they try to bring inappropriate issuers and inappropriate structures, it’s up to us as investors to say ‘no’.”
No wonder originators and syndicate desks suddenly sound unsure. Of course, they want to believe that the market will grow and prosper and mature and still be around in 10 years’ time. It’s the next 12 months that is hard to judge. “I’d expect another €10 billion in Europe this year, similar to last,” says one originator. But then he qualifies himself. “Maybe €5 billion,” he says.
Surely one big deal a month should be possible if this market is to prove itself? “I honestly can’t say,” says another originator. “We’re in very close discussions with three issuers and last month if you’d asked me I would have said there’s a 75% chance all three will do deals this year. Today, I’d say the chances of that are less than 40%. Ask me again next month.”
