| Hybrid Capital 101 |
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| 01/05/2006 | |
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Philippe Henry, Head of Debt Finance & Advisory, and Jean-Philippe Brioudes, member of the Debt Origination department at HSBC France, answer this week's 101 on hybrid capital. 1- What is hybrid capital? Hybrid capital (or hybrid debt) is a transposition of the regulatory capital of financial institutions (Tier 1 and Tier 2) to the corporate world. Its main features are its permanence, the possibility to delay the coupons, and the subordination of the principal. From the issuer's standpoint, hybrid capital is analysed as owner's equity by chartered accountants and rating agencies. Moreover, it is cheaper than ordinary capital; it is generally tax-advantaged (since it is assimilated to debt from a legal point of view); and does not cause any dilution for existing shareholders. Hybrid capital securities are usually structured as perpetual or ultra-long debt that are subordinated to all other financial instruments save for common stock, and pay out a fixed rate during their initial period. They then start to float if they are not called in by the issuer. The coupon is usually linked to the payment of a dividend as well as to a credit ratio. Unpaid coupon can be delayed and cumulated. From a rating agency's viewpoint, bonds payable in equities within three years are the hybrid products that get the highest equity credit. 2- Why has hybrid capital grown quickly over the last few years? The quick development of hybrid capital among corporate issuers is due in part to the introduction of the IFRS as well as the rating agencies' explanations about their stance on this issue. By all means, rating agencies' analysis of hybrid capital of financial institutions and corporate issuers is getting increasingly similar. The experience acquired on the hybrid capital of financial institutions by the players on this market (banks, consulting firms, chartered accountants, rating agencies and investors) has been transposed onto the corporate hybrid capital market. Low sovereign interest rates, as well as historically low credit spreads, have acted as strong incentives for investors to become interested in those new products, which generally offer higher yields. About €10bn in hybrid capital securities have been issued since 2005 in Europe. There are many uses for this type of instrument. Some companies use it for the refinancing of M&A operations (e.g. Linde, Vinci, Bayer), while others use it for financing a pension deficit (e.g. Henkel), or to strengthen their balance sheet (e.g. Porsche, Thomson). The investor base for those products is wide since it includes traditional institutional investors looking for spread, as well as retail investors such as private banks, especially on the Asian US dollar market. 3- Is hybrid capital the kind of assets that should be included in the portfolio of a pension fund? Why should institution get exposure to hybrid capital? In the current low-rate, low-spread context, hybrid capital offers an interesting investment opportunity for investors looking for high yield. A hybrid capital product generally offers a credit spread that is four times higher than the 10-year senior spread, that is, about 200-300 basis points depending on the sector and the rating of the issuer. Besides, since the beginning of 2006, hybrid capital securities are included in the iBoxx bond indices. That means that any investor willing to track the performance of this market has to be exposed to hybrid capital. However, those investors should keep in mind the risk that comes along with those instruments through a thorough analysis of the information provided in the prospectus of the targeted security (level of subordination, possibility to delay or not to pay the coupons, as well as the presence of a clause of ownership change). Investors could avoid serious problems by doing so: in the United States, the NAIC (National Association of Insurance Commissioners) has just reassessed the debt capital instrument of a financial institution into equity, which has led insurers to use up more reserves for this investment since the risk of equities is higher than the risk of debt. |
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