RBS: An Effective Equity Substitute – Richard Bartlett
During the economic downturn, the corporate hybrid bond was deemed by many to be on the verge of obsolescence. Richard Bartlett of RBS tells Rod James about the instrument’s resurgence and how it can help contribute to a strong and balanced corporate capital structure.
With the effects of the credit crisis and impending introduction of the Basel III regulations, risk is the new watchword in the world of corporate financing. Capitalisation has become a challenge for all companies, as the certainties of bank lending come into question and equity markets prove reluctant to offer companies the additional support they need. According to Richard Bartlett, head of debt capital markets, EMEA, at RBS, these factors, and the low-yield environment they have created, are driving the resurgence of hybrid capital.
Hybrid instruments combine characteristics of debt and equity. Like debt, payments on hybrids can be tax deductible and non-dilutive from a shareholder perspective. However, they are subordinate to other debt and must be long dated, reducing the pressure to repay and even allow for the suspension of interest payments if the business environment becomes difficult. Their equity-like qualities are recognised by ratings agencies, allowing firms to access an equity substitute without their ratings being affected by the additional debt.
"Hybrid capital bonds are fixed income instruments that don’t dilute equity," Bartlett explains. "They can be treated as having a high degree of equity content by ratings agencies when examining the credit metrics of a company due to their loss-absorption characteristics."
High-yield assets are proving popular in today’s market, particularly those connected to larger, well-established corporate names. Although the concept has been around for a number of years, with transactions being carried out during 2006-08, the scale of 2010’s hybrid bond offerings has been unprecedented.
"If we take RWE just a month or so ago, that was a €1.75bn hybrid bond with a 50% equity credit structure," Bartlett explains. "The ability to do transactions of a significant size has made hybrid capital much more relevant to a broader range of corporates."
Strength of the bond
The underlying principles of hybrid capital in its 2010 incarnation have not changed, although the concept is, according to Bartlett, better understood than it was, making for more reliable financial instruments.
"There has been a lot of focus on hybrids in terms of whether or not they actually absorb loss. Do they have the characteristics to validate the rating agencies’ belief that they can be treated, at least partly, as equity?" Bartlett says. "I think the precise terms regarding when interest and principal is and isn’t paid, whether interest rolls up or not, or whether it’s compounded, have evolved. Loss absorption characteristics, as well as the associated level of equity content ascribed to hybrids containing those characteristics, are a lot more evolved than before."
The issuance of such bonds is becoming prevalent throughout Western Europe and Asia, with investors deriving mainly from a fixed-income base. What is noteworthy is the number of firms getting involved. The question was always whether there’d be sufficient investor appetite to elevate hybrid bonds above being just a niche instrument. Recent corporate hybrid transactions, particularly one involving Dutch electricity utility TenneT, suggest that there is.
"TenneT was the first corporate hybrid to be executed postfinancial crisis, the first rated deal for about two years," Bartlett explains. "It was a €500m transaction, but we saw about 200 investors participating. Interested parties are emerging from across Europe."
Such regulated utilities are particularly suited to hybrid markets. The long-term nature of their operations and countries’ constant need for new infrastructure has led to significant capital investment in the sector, even as companies in other industries draw back.
"Investment in power stations and grids continues on a much longer-based cycle, away from the movement of the markets," Bartlett explains. "These institutions will benefit considerably from the re-emergence of the hybrid market."
The rise of the hybrid bond is, in many ways, a reaction to the shock of the credit crisis. FDs and treasurers are beginning to understand the importance of diversification in terms of where a company derives its capital, whether directly through bond markets, from insurance companies or by diversifying across currencies.
"We all know about diversification in terms of our personal investments, but the crisis showed us that many things we thought weren’t correlated actually are," Bartlett explains. "Clients are seeing that having 15 or 20 banks gives you some degree of diversification, but it’s only along one dimension, and if something happens to the whole banking market simultaneously, you need to be able to tap into other sources."
This is causing many companies to rethink their capital structures, with the market placing more emphasis on the amount of liquidity a company has at its disposal. In the US, Bartlett explains, companies are generally financed about 75% through the capital markets and 25% through the banking markets. In Europe, the situation has been the reverse, although there has been a clear sea change of late.
"In 2009, when we look at actual volumes, the split in Europe was much closer to 65:35," Bartlett says. "We think this trend will continue, with a greater level of corporate issuance in the bond markets. That’s been very noticeable with companies with weaker investment grade ratings, down into the sub-investment grade. "
This structural change is undoubtedly being influenced by regulatory changes made in the wake of the credit crisis. Bartlett sees these regulations having a profound effect on the way banks and their clients do business, highlighting over-the-counter derivatives and Basel liquidity rules as an example.
"The US and Europe are looking to push a much greater proportion of standardised or eligible derivatives transactions through central clearing," he says. "Moving transactions through clearing houses would help reduce the degree of systemic risk should any one market counterparty fail."
In Bartlett’s opinion, the new regulatory environment will lead to a clear distinction between bespoke and standardised derivatives, with the former becoming much more expensive to transact due to the need for greater levels of capital held against those bilaterally cleared derivatives.
"The general thrust of the rules means that bespoke derivatives executed between a corporate and a financial institution will become much more expensive because the amount of bank capital that has to be provided for them will increase," he says. "Conversely, standardised derivatives, which can be cleared centrally via an exchange or electronic platform, should become cheaper, because there will be lower levels of capital required and greater price discovery. Going through a central counterparty and an exchange or platform will reduce the amount of risk in the system."
Things are further complicated by Basel III’s liquidity proposals. These require banks to hold, and fund, high-quality asset pools on the assumption all liquidity commitments will be fully drawn under a short-term stress scenario. "It remains to be seen how ratings agencies will react to issuers seeking to reduce the level of bank liquidity support for their CP programmes, but the inevitable increase in cost of such facilities is likely to force corporates to examine funding options.
All of these market factors point to the continued resurgence of hybrid capital over the medium term, even if at this time banking markets are proving strong. With companies diversifying away from the banks and capital usage levels being generally low, many banks find themselves under-lent and are lending aggressively as a result. This, in Bartlett’s opinion, is a short-term situation that will soon give way to a more conservative approach, with hybrid bonds playing a significant part.
"Banks’ capital bases have been reduced in recent years and will be further depleted by the introduction of Basel III," he explains. "The corporate hybrid platform allows companies to invest in some of the best known companies across Europe and to earn extra yield by supporting them at a lower point in their capital structure. We are seeing an evolution of the product into mainstream structures."