BNP Paribas: Capital Thinking – Thibaut Adam
Thibaut Adam, head of capital markets structuring at BNP Paribas, explains to FDE the significance of the revival of hybrid capital markets, its key drivers and how new rating frameworks have affected investors and issuers.
FDE: What is driving the activity in the corporate hybrid market?
Thibaut Adam: The revival of the corporate hybrid capital market is well under way, boosted by the economic environment. This has been driven by several factors. Firstly, Moody’s published its equity credit methodology for hybrid capital on 1 July 2010, which took into consideration hybrid performance through the financial crisis.
Secondly, low swap rates are leading to low absolute returns. Moreover, there is a lack of competing supply because banks, faced with a shifting regulatory environment, are not issuing. Finally, there is significant investor appetite for higher yielding assets in the current climate.
Moody’s revamp of its methodology has cleared the way for increased issuer activity. Adopting a principles-based approach, it has resulted in greater transparency and a deeper investor base because structural complexity is reduced.
Essentially, it has enhanced the investor marketability of hybrid structures. Meanwhile, the Standard & Poor’s criteria have been relatively stable since they were put in place in 2003, aside from a change in replacement provision in 2007. The stability of the rating agency framework is key for corporate issuers.
FDE: Why have the four announced transactions been the utilities Tennet, SSE, Suez Environnement and RWE?
TA: While utilities have so far dominated the recent spate of hybrid capital transactions, the market is not restricted to just these entities.
Investors feel more comfortable with companies that rely on the bond market for their refinancing and that offer stable and predictable cash flows [utilities have sizable capital expenditure requirements]. We fully expect issuers from other industries to tap into the market.
FDE: Has the corporate hybrid market changed since it kicked off five years ago?
TA: There has been a fundamental shift in market dynamics. The banks that once dominated issuance now only issue a fraction of what they used to. Meanwhile, investors are keen to buy higher-yielding assets from well-known names, resulting in the potential for much larger transactions than were previously considered.
Moreover, the market is more mature. Investors’ experience of extreme stress with subordinated bank debt means they understand the risks associated with the instrument.
FDE: Does the relative risk aversion towards subordinated bank debt highlight the benefits of corporate hybrids?
TA: The rarity of blue-chip corporates has ensured that they have outperformed bank paper, therefore resulting in a low coupon. In addition, uncertainty surrounding the regulatory treatment of bank securities has led to a more cautious investor climate.
FDE: What are the key drivers for pricing?
TA: Corporate hybrid performance has fared well since the beginning of the financial crisis. The increase in beta during this time was more gradual for corporate hybrids compared with financial subordinated debt, helping corporates to outperform over the period.
In the current low-yield environment, some investors are finding hybrid securities attractive, giving them an average yield pick-up of about 2.5% over senior debt, therefore satisfying investor’s yield targets compared with other asset classes. Corporate hybrids, on average, provide a yield of 5.4%, compared with a dividend yield of 3.3% for the DJ Stoxx 600 index. Even at the individual bond hybrid level, the bond yield surpasses the equity stock yield.
FDE: Rating agencies have revamped their frameworks over the past two years. How have issuers or investors been affected?
TA: In the past, with each deal being different, significant due diligence was required for each transaction. The convergence of new rating frameworks means the instruments are more standardised, which provides transparency for investors.
For issuers, there has been a simplification of some clauses. For example, the use of alternative coupon settlement mechanisms to pay a deferred coupon is no longer necessary, allowing for cumulative payments of interest, which in turn leads to best pricing. Features linking hybrid payments with ordinary share payments are generally included to ensure payment discipline, such as dividend pushers/stoppers and interest on interest.
The recent changes by Moody’s and Standard & Poor’s can be viewed as an indication that the instruments are now mature. The new frameworks take into account several years of issuance as well as evolving technology, while the financial crisis has also provided a real-life stress test for hybrid instruments. As all instruments incorporate capital disqualification language, giving the issuer the option to redeem or vary/substitute the securities if the equity credit is weakened, issuers may mitigate the cost of any future changes, which are less likely than before.
FDE: Rating defence is a key preoccupation for CFOs, but where do corporate hybrids fit into the picture?
TA: A hybrid is an attractive instrument in the CFO toolbox. It is a very effective way to rebalance the capital structure following an acquisition. However, it cannot address all rating pressure matters. If the source of rating weakness stems from operational rather than financial structure issues, its success is limited.
FDE: How does the low absolute swap rate influence an issuer’s decision?
TA: A number of corporates seek investment opportunities on the basis of their absolute return, then look at the best capital mix to optimise shareholder value within various rating constraints. In this context, a tax-deductible hybrid priced in the very low interest rate environment will reveal a favourable after-tax cost.