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Two-way Tools

Companies are issuing a new breed of security that blends debt and equity. But investor demand for such hybrids may not be as great as banks hope.
Ronald Fink, CFO Magazine
June 1, 2006

Hybrid securities, such as convertible bonds and preferred stock, have been in the financial manager's toolkit for decades. They blend elements of equity and debt and can be treated as either one, thereby limiting the amount by which earnings are diluted or leverage added to a balance sheet. Now, a new generation of hybrids has won the blessing of ratings agencies in ways that the earlier ones did not. Bankers claim that companies can use the new hybrids to fine-tune their balance sheets as they see fit.

One company that recently did so is Burlington Northern Santa Fe, which issued a $500 million trust-preferred security last December. The hybrid enabled the railroad company to raise capital and buy back stock without changing its ratio of debt to equity. While Moody's Investors Service considered the hybrid to be 75 percent equity and 25 percent debt, Burlington repurchased enough equity to equalize the effect on its balance sheet.

"We lowered our cost of capital," comments Linda Hurt, Burlington Northern's treasurer, "but we kept our current capital structure." While Hurt declines to quantify the cost savings from the hybrid, which has a 50-year term, she says they are "significant."

Until last year, issuing such a security risked a company's standing with one of the two ratings agencies that dominate this corner of finance, since Moody's considered hybrids to be debt. Then Moody's changed its mind, following a 2005 decision by the Federal Reserve Board to allow internationally active bank-holding companies to hold up to 15 percent of their Tier 1 capital in the form of trust-preferred securities. Moody's announced that it would go along with a previous decision by Standard & Poor's (S&P) to view hybrids partly as equity. The ratings agencies now assign to a hybrid issue a degree of equity content based on several criteria.

A key criterion is whether a hybrid allows issuers to skip payments entirely rather than merely defer them. That's how the new hybrids are typically structured, which is what helped convince Moody's to treat them as equity. In theory, Moody's could consider a hybrid to be fully equivalent to equity, while S&P won't go higher than 90 percent equivalence.

Banks, which were already issuing their own hybrids for their Tier 1 capital, took Moody's decision as a go-ahead to underwrite new corporate issues of trust-preferred securities. "The decision by Moody's kick-started frantic activities among the banks," notes Thibaut Adam, head of hybrid capital structuring for French bank BNP Paribas.

Open Questions
But several key questions about hybrids, particularly those issued by companies, remain unanswered.

One concerns tax deductibility. For hybrids to be feasible, the Internal Revenue Service must see them in the opposite way that ratings agencies do — as debt, not equity. Otherwise, issuers can't deduct as interest the periodic payments they make to investors. Officially, the IRS has been silent on this issue, but banks say private discussions with the agency have convinced them that it will go along — on condition that the securities qualify as debt, including the requirement that they aren't "perpetual," as equity nominally is.

Even if the banks are right about their private discussions, there's always a risk that the agency will change its mind. For that reason, all U.S. deals include a tax call provision, under which the security would be redeemed if the tax deductibility of investor payouts is lost, notes Pamela Fitton, a managing director of BNP Paribas. European issues can forgo the provision, because international accounting rules allow interest payments on equity and other perpetual securities to be deducted.

Accounting poses another potential problem for U.S. issuers, as U.S. GAAP treats hybrids as debt instead of equity. As a result, while an investment bank might convince a company to issue a hybrid, a commercial bank might penalize the issuer, because the hybrid raised the issuer's debt levels in violation of loan covenants. It's even conceivable that a multiline bank could find its investment bankers in conflict with its loan officers over the matter.

Much depends on how rigidly the covenants follow the accounting regime. "If a covenant is written without a lot of flexibility in that regard, you're stuck," observes Charles Mulford, an accounting professor at the Georgia Institute of Technology. In that case, an issuer would have to sit down with its lender and renegotiate its covenants. Burlington Northern's Hurt insists that her company has no problem with its loan covenants as a result of its hybrid, even though the covenants closely follow GAAP.

Still another hitch with hybrids is that they may increase the possibility of a hostile takeover, as happened with convertible bonds in the late 1990s (see "Pick Your Poison" at the end of this article).

Investor Skepticism
A more fundamental question is whether the new hybrids will find buyers. While much of the cost advantage of hybrids depends on favorable tax treatment, the rest depends on pricing. And if investors grow wary of the risks involved, some if not all of the promised cost advantage over straight debt and equity could disappear.


So far, the record here is mixed. The spread over yields on 30-year Treasury bonds at which Burlington Northern's hybrid trades has shrunk since issuance. But the spread has widened on a hybrid issued by The Stanley Works, which intends to use the money raised for acquisitions. It may be, in part, that investors are more confident that Burlington Northern's stock buybacks will add value than The Stanley Works's acquisitions will.

There are other reasons for investor skepticism. Hybrids are junior securities, deeply subordinated to straight debt. And issuers can skip payouts without triggering a default, just as they can with dividends on equity. While that prospect wouldn't concern an equity investor, it may trouble a bond investor, particularly when missed payments aren't deferred. Indeed, the more a hybrid resembles equity, the more skeptical of it a bond investor is likely to be.

Some investors are warier of industrial hybrids than of those issued by banks or insurance companies, says Kevin Murphy, a bond fund manager for Putnam Investments in Boston. "With insurers and banks, the business model is not likely to change" during the term of the hybrid, explains Murphy. In contrast, some industrials will have to change their models during that interval. (That's what The Stanley Works is trying to do, notes Murphy.)

But investors have been leery of bank-issued hybrids, too. That certainly seems to be the case with a hybrid issued by Washington Mutual in February, as it began trading at a widening spread over Treasuries soon after it came to market. In this case, the hybrid was issued without a term, and "investors began to focus on the perpetual nature of the transaction," noted a BNP Paribas newsletter last March.

Investors may also remember what happened during the Asian financial crisis of 1997, when the U.S. bond market took a big hit. Prices of bank-issued hybrids were much slower to recover than those of Treasuries and corporate bonds. If there is a fresh bout of financial stress, hybrids are again likely to be hit harder than traditional securities, says David Hendler, an analyst for CreditSights, an independent credit-research firm. "They're going to perform poorly, just as all junior securities do," he says.

Market Setback
Perhaps it's not surprising, then, that hybrid issuance in 2006 hasn't been as strong as initially predicted. As of early March, almost $9 billion worth of hybrids were reported to have come to market. At that rate, the total by year's end would exceed last year's total by 50 percent. Still, that rate is considered disappointing, as BNP Paribas noted in its newsletter.

The market also took a big hit in late March from a decision by the National Association of Insurance Commissioners to treat a hybrid issued by Lehman Brothers as common stock. The ruling sharply limited how much of the hybrid insurance companies can hold. Since insurers are estimated to represent about 25 percent of the potential market for hybrid investment, the ruling has cast a pall over new issuance. Investment banks are lobbying hard to reverse it, says one investment banker, who asked not to be identified, but no action had been taken when this issue went to press.

If, for whatever reason, investors in hybrids remain standoffish, issuers will have to offer them more-generous terms. That would undermine, if not defeat, the new securities' very purpose.

Ronald Fink is a deputy editor of CFO.


Pick Your Poison
Could Hybrids Become Takeover Tools?

Remember toxic convertibles? During the late 1990s, some convertible bonds had provisions that required companies to issue more stock if the price of the underlying equity didn't reach a certain level by a certain date. By selling the underlying stock short, hedge funds and other corporate raiders forced weak companies to issue more and more equity, putting downward pressure on its price. Ultimately, that induced a "death spiral" that allowed the investors to acquire control at minimal expense.

Some experts warn that the same risk may be present in new hybrids like trust-preferred securities, because their provisions typically require the issuer to replace the security with an equivalent one when the first is "called." For that reason, Thibaut Adam, head of hybrid capital structuring for BNP Paribas, advises hybrid issuers in a weak financial position to include antitakeover provisions in their terms.

Several issuers have already done so. Washington Mutual included a poison pill in a hybrid it issued in February that provides additional voting rights for holders upon a takeover attempt, while Thomson of France and Tui of Germany have issued hybrids with call provisions if their credit ratings fall below a specified level.

Burlington Northern, for one, saw no need for the protection. "Our credit is strong," says treasurer Linda Hurt. But antitakeover mechanisms are likely to appear in other new hybrids if and when a raider like Carl Icahn sees sufficient opportunity to use them. — R.F.


Hybrids Flower
Recent issues of hybrid securities
Company Date Hybrids sold
(in $MM)
Maturity/Coupon Equity Content* Issue Spread
(basis points)**
Current Spread
(basis points)**
USB Capital IX
(US Bancorp)
3/14/06 $1,250 Perpetual/6.2% fixed, then floating 75% +150 +153-148
Wachovia
Capital Trust III
1/24/06 $2,500 Perpetual/5.8% fixed, then floating 75% +142 +133-128
Burlington Northern
Funding Trust I
12/12/05 $500 50-year/6.6% 75% +187.5 +168-163
Stanley Works
Capital Trust
11/15/05 $450 40-year/5.9% 50% +140 +169-167
Lehman Brothers
ECAP
8/18/05 $300 60-year/LIBOR + 78bp until 2010, then +178bp 75% LIBOR + 78 LIBOR + 74-69
*Equity content as determined by Moody's Investors Service. **Spread over U.S. Treasuries except where noted.
Source: BNP Paribas



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