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In Mizuho | Greenhill’s Beyond The Obvious podcast channel, we uncover the value that others miss.
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00:00:03:16 - 00:01:18:04
Hello, my name is Moshe Tomkiewicz, Head of Investment Grade Debt Capital Markets. We wanted to get together with you to discuss hybrid capital. We've seen issuance volumes
for hybrid capital spike three times relative to last year,
while at the same time we’ve seen subordination premiums
basically brought to record lows We've seen a broadening of the
applicability of hybrid capital to US corporates, as well as an expansion of the demand pool for these types of securities. So what we wanted to discuss today is exactly what is hybrid capital, the applicability of it, and the art of the possible as this type of security becomes more front and center,
especially as M&A continues to accelerate. So joining me today are Victor Forte, Head of Investment Grade Capital Markets and Syndicate, Katie Lavino, Managing Director from Syndicate as well, and
Jee-Won Yang, Managing Director and Head of Structured Solutions So why don't we start the conversations you want with just quick definition of what is hybrid capital? And what's changed over the last year or so that's kind of widened the spectrum of
applicability of the product? The hybrid capital securities
are a fixed income instrument
00:01:18:04 - 00:02:27:23
that has equity-like features. And for that reason, rating agencies provide
partial equity content. And these are not convertible into equity at any point in time. So that is what is a little bit different from the equity product versus debt capital
markets product. In terms of the uptick
in supply this year, what really spurred the increase
in interest from issuer space this year has been
Moody's methodology change for hybrid capital securities. Up until now, and it has been always a 50% equity content product from S&P and Fitch for tax deductible format. But what we've seen this year in February is that Moody's came out with a revised criteria which allows tax deductible hybrids to
receive equity content of 50% instead of 25 for US corporate issuers. 50% instead of 25 for US corporate issuers. That's a pretty big deal because if you're dealing with a situation where you're getting 50% equity treatment, 50% debt treatment tax deductible,
then that becomes economically attractive for those issuers that need capital.
00:02:28:17 - 00:03:04:21
What have you, and I'll throw this over to Katie and Victor, what have you seen in terms of which clients are using this product right now and which clients, more importantly,
do you expect to see using this product going forward? I think you have to also look back at the Moody's change was a big thing, obviously, but I don't think it was the only thing that led to the growth in hybrid capital. We're in a moment right now where because of capital expenditure needs, the utility
sector has an enormous need currently and going forward for
equity content to shore up their ratings to make
sure they stay consistent.
00:03:04:21 - 00:03:28:14
They are now able to put a fully tax deductible product that gets 50% equity in the context of other equity products that they can use, whether it's block equity, convertibles, etc. I think that's been another thing. We've coincided this move at Moody's to just the right time when at least currently the biggest non -financial users of the product
have been the utilities at this moment.
00:03:28:17 - 00:04:25:29
I think that's led to a huge growth here over the last year. I think it's going to continue right now
going forward. I would echo those comments
that utilities, obviously, when you look at the
percentage year-to-date of how much hybrid capital came from corporates, the number’s roughly about 80% coming from utilities. I don't know if that number will remain stagnant and to Moshe's point of there's been some recent executions from US corporates that have used this in a way that really helped them, I would say, manage their liability towers in an efficient manner. I do think that in the future, in 2025 and beyond, it will become much more, to steal Moshe's comment, the art of the possible in the hybrid market, but I do think it will maintain a very core product in the utilities’ space, particularly as data centers, AI, all of this needs to be funded via the utilities. I think that we'll continue to see utilities as a main, I would say, sector for the product, but I think the possibilities are endless.
00:04:26:22 - 00:05:32:11
And I think what's going to trigger the conversation about the art of the possible is going to be M&A. We are out with a survey, and I think investors expect a material pickup, if not a record level of M&A-related supply. Some of those transactions will not be in a position to be all debt financed. Some of those transactions will need to have an equity component, and that's where
hybrid capital is going to step in. And the question is one of quantum. When Victor, you and Katie, when you think of size, when you think about the art of the possible and hybrid capital, and I'm thinking this in the context of M&A, what type of numbers are you all thinking about? Well, I mean, look, I think you have to step back one moment and say that I think if people hadn't had their eyes open the last five years, they might have missed it. And I think a recent issuer who just did $3 billion outside of the utility space, non-financial issuer, who had a book size that at the peak was borderline in the market between
$18-and-$20 billion, I think that opened a lot of people's eyes to what is the art of the possible in terms of size.
00:05:32:22 - 00:06:13:24
Because right now, you knew this, you're having conversations with a lot of issuers saying doing a billion or $2 billion of a hybrid that only gets 50% equity content didn't move the needle at all But now people's eyes were open. The funny part was if you go back four and a half years, there's a UK issuer who did $5 billion in the US in one shot and also added euros. On top of that, to get a quantum that was much closer to $10 billion. So we've been able to do size, I think, for quite some time. But I think this recent trade and this recent run up in the hybrid market has crystallized to people that doing $10 billion of hybrid in the US market is not something that is unattainable or not doable at a relatively reasonable coupon. Wouldn't you agree? 100%.
00:06:13:24 - 00:07:18:26
I would say 10 is a good number for particularly an M&A exercise. When you're talking about CUSIPs in
particular, just like tranche sizes, and we were talking about this, but $2 billion is digestible, easy. There's a little bit of size premium there. But when you're then thinking about
an overall exercise of, again, looking at an overall cap structure, I think 10 is probably a good number for a large exercise. And I think from an investor perspective, and you guys correct me if I'm wrong, if you're sitting there and you're looking at an
economic backdrop that is stable to resilient, your goal then is to maximize yield and fixed income. So you're either getting more
cyclicality in your book, riding down the credit curve, or you're buying subordinated capital. And that's where this comes into play. I mean, look, I think a lot of investors, if I look at the last year and a half, having done this for a long time, I would argue that the people or the number of investors of the book that's chasing after these deals is double what I used to deal with a decade ago.
00:07:19:15 - 00:08:16:12
That buyer base has grown enormously, and a lot of it has been the fact that it's become more mainstream as well. People who avoided it in the past because of very small issuance. You can't be an investor in a utility sector without coming to grips with
what's being issued right now and understanding it. And once you understand it, you realize there's a role for it in your portfolio. And also, look, with the big bid for duration and particularly yield right now, in particular,
that's driven a lot of people into this product. And I would also say from Jee-Won's
standpoint, she could probably discuss this, there have been structural changes that are now allowed at the agencies that deal with what happens when a bond extends that has driven another 25% increase in the buyer base for this because it changes
structurally what some things people were worried about in the past. You can go through some of those right now, and that also helps increase the
buyer base going forward.
00:08:16:21 - 00:09:19:28
So in terms of the structure, there are a very strict set of features that you need to have from rating agencies. One being maturity, it cannot be anything less than 30 years, and issuers have par call option year five, year 10, but we're also thinking about more widespread of different call features for some of the issuers right now. So that's something that we're exploring. It has to be deferrable and it has to be subordinated. But in addition to that, we are also exploring, and we have explored various structural
features that doesn't impact rating agencies' view on
equity likeness of hybrids, but at the same time, from investors'
perspective and from issuers' perspective, it can
actually help them save upfront coupon savings because
investors can see this as there is a certain certainties in terms of the coupon that they will get in case it gets extended after the first call date. And the most prevalent structure that we brought to the market this year is the coupon floor.
00:09:20:15 - 00:10:15:19
So it has been done in high-yield market. We have not seen in investment grade market, and what it does is when the issuers issue the instrument, the hybrid gets
extended after the first call date, the reset won't be less than initial coupon. It's just important to highlight to people that the standard reset structure was off a current five-year at that time, plus the spread. So you still had an unknown as an investor of what your rate was if you were extended, whereas in our structure, that year yield is floored. But that's why investors, look, there was a pool of investors out there that didn't like the idea that they didn't know at least what the minimum coupon was going to be on an extension. Here, if the issuer choose to extend, they at least know that. And what has that done? It's bought down front-end coupons. I know there's debates on this in the street. In every deal we've been in, it's lowered the front-end coupon by at least 25 basis points, if not more.
00:10:16:07 - 00:11:23:08
It's also led to a bigger book in terms of demand for the trade, which has taken price breaks down in all the issuers that have seen them And I would note that all of the securities that are tax deductible and have floors in them have been some of the best
trading securities within the hybrid market as well because of the effect that that floor has as things rally and what it means for the duration of the security. Victor, so just walk us through
the subordination premium or the premium relative to senior. Yeah, I think there's a lot of people out there who think in terms of subordination premium, we've always tried to change that dialogue because there is subordination premium and there's extension premium. And a lot of people believe in structures where, say, a 30 non-call 10, where Jee-Won had mentioned some of the, it has to be at least 30 years, but on a 30 non-call 10 where your first call date's at 10 years, that 10 years coincides with the loss of equity content from one of the agencies. And a lot of people believe that that puts a theoretical kind of reset date or a renewal date that someone's going to call that security at the end of 10 years.
00:11:23:20 - 00:12:02:27
On a five-year, on a 30 non-call five, the issuer has the option to extend for another five years and still get full equity content from all three agencies, which
I think is very important. So in that security in particular, extension risk and what will extension look like to me is very important to investors. And that's why we've seen people be willing to pay issuers to provide that floor because that floor at least gives a minimal consistency going
forward and protects them on extension risk that if it extends, I have a minimum coupon. And I think that's been a big factor change. Is that extension risk the reason why we were seeing some five-and-10-years priced with an inverted curve?
00:12:03:11 - 00:13:05:19
Well, yeah, if you think about it, right, if I just take a utility, for example, and say most utilities have about a 25 basis point, five to 10 spread curve, and the treasury is what about 10, 15 basis points, you're talking about a 40 basis points yield differential in debt. Yeah, we were pricing them flat to inverted in hybrid for non-call fives versus non-call 10s. And so when you invert the curve by, you know, call it 40 basis points of yield, you flatten it by 40 basis points of yield and you invert it by another 10-to-12, you're talking about a 40-to-50 basis point lower subordination level for your non-call 10 versus your debt than your non-call five versus your debt. That to me is representative of the fact that yes, I could chalk it up to a quote ‘bid for duration’, but that same bid for longer dated securities would have reflected itself differently in senior debt as well. But in hybrids, that reflection is because I can as an issuer extend that five-year. So I think the opportunity of extension,
that extension risk is that 40-to-50 basis points. And can the floor save you a
good chunk of that? Absolutely.
00:13:05:19 - 00:14:03:25
Can it save you all of it? Probably not because you don't own that option as an investor, the issuer does, but it can save you probably more than half of that. Now Katie, that sounds like that will have capacity implications, right? It does. And it's a twofold answer
because first and foremost, I think our credit strategy estimates right now for the total IG population of credit, about 80% of it is yield buyers. When you think about the funds that buy these hybrid securities, it's predominantly income funds. They haven't seen these coupons since 2007. And so it's almost like a 20-year type of moment for them to buy these coupons. So you're giving them certainty of income essentially with these coupon floor products, then that's
why they're willing to buy up for it. That's why they're willing to pay that 25-plus basis points that Victor mentioned earlier, is because they haven't had this certainty of income. And when you're thinking about
asset and liability matching, particularly for insurance, LDI funds, right? Long Duration Income Funds, they ultimately,
they need this type of paper.
00:14:04:01 - 00:15:13:01
And so that's why they're willing to pay up for it is because it's guaranteeing both an income stream, but also again, from a coupon floor is that if they do get extended, they know how to hedge it. And you know that without that coupon floor, some recent deals would not have gotten the size that they went for in the non-call five relative to the non-call 10 at the time they did it. Particularly not at the level they got done. No, correct. Can you guys talk to me about secondary trading and liquidity in these securities? Because as we see more
non-traditional hybrid buyers come into the market, is there going to be enough secondary balance sheet to
support all that issuance? First and foremost, because a lot of these investors that are buying it, that are income funds, a lot of it gets put away. And it's put away and they don't really care if it trades at 95 or 105 on the break. The faster money that has been involved
obviously cares. And that's really when the secondary
picture comes into play Here at Mizuho, we're very lucky to have two of the best hybrid capital trader
and hybrid salesperson on the street. It's one of, I think, only two teams on the street that are fully dedicated to the hybrid preferred AT1 product.
00:15:13:19 - 00:16:37:11
And because of that, we are putting our own balance sheet behind it. I do think as the upswing in issuance tends to do, primary, as we all know, has been leading secondary since about 2020, if not earlier. And I do think that the upswing in primary is getting the attention of the secondary desks, that I do think that others will be putting balance sheet to work. I just don't know, one, if they'll be fast enough, or two, if they'll be able to catch up the people who, again, like Mizuho,
are specialized in the product at this point. If you don't trade hybrid now, you're missing out on a huge part of the market as a secondary desk and a ton of potential
profitability that you didn't have a year-and-a-half ago. And Katie, in terms of the next year's supply, we have a very large optional
redemption tower next year but most of it is the AT1 products. I know Europeans have pre-funded most of it, but for US issuers, the preferred layer of their regulatory capital structure is kind of going away, so how do you think that's going to play in terms of demand and supply dynamics for next year? So it's an interesting question, because the preferred product does go into a little bit of a different bucket, because there are some tax positives on the investor's side for buying that. But I do think that, to your point, with the uncertainty of the regulation in the bank world, particularly, of that they might not rush to market to refi those until they get more clarity on that.
00:16:37:25 - 00:17:35:12
And then you do have an element of what generally was a majority of the issuance for the better part of the past five years from the financial industry not going away, but for sure lighter, that that capital will have to go somewhere. And I do think that that will flow into the corporate hybrid space. So we're getting a lot of people engaged on the product. We're having non-traditional users of the
product rolling up their sleeves and issuing. And it's all predicated on the treatment
we're seeing from the agencies. We obviously had a constructive development with Moody's this year, but what happens or what is the chance that we see it going the other way on us? And how can issuers protect themselves from that? So out of the three rating agencies, Moody's has always been the outlier in terms of the tax deductible hybrids for US corporate issuers. And they have actually moved to align with S&P and Fitch, and they have not changed their criteria on hybrids for many years.
00:17:35:21 - 00:18:43:13
So in a way, in my view, at this point in time, I really don't think that there's going to be a very quick change in heart in terms of how Moody's, or even like the other two agencies, to have different view
on these securities. I think what rating agencies do time to time is that they look at certain features and think about, is this the right way to think about it? I mean, S&P just came out with a request for a comment about sliding step up. It's a very niche topic, and they would continue to sort of tweak that. And that's the reason why when we advise our issuers, we want to make sure that they have an open conversation with
rating agencies, and we run the structure with the agencies to make sure that there are no surprises. On top of that, all hybrids, there is a rating agency event calls. So it's structured at 102 in the US Some countries, for some issuers, it is at 101. But what it does is, if there is a change of rating agency criteria that triggers a loss of equity content, then there is an out from issuers. And also, when you think about it, all these instruments, there is a par call option.
00:18:43:24 - 00:19:41:25
So that risk is depending on whether it's a non-call five, non-call seven, non-call 10. The risk is within that period of time. Because beyond that point, you can call it a par. I also think the more of these securities that are issued, and they're issued based off of this rating agency treatment, it becomes
that much harder for the rating agencies to go the other way. Jee-Won, a question for you, though. So how many of these securities,
during their non-call periods, also have the callability,
just for any reason? Have they instituted a make-whole call? And is that allowed? Not allowed? How has that been going? So that's one thing that changed over time, but at the same time, right now, what has happened is it was more conservative, and now it's
more lenient. So issuers do have ability to have a make-whole option before the first call date. And the one thing I would add to that is, when we're thinking about a change to the rating agency credit, it also goes kind of hand -in-hand with regulators as well.
00:19:42:04 - 00:21:10:09
So I think as long as the regulator doesn't move first, I would imagine that the rating agency, well, to your point, would not surprise the market. Let me give you guys another question. Say we're in an M&A situation. Client wants to raise a significant amount of equity, of hybrid capital, but really won't need it three years from now, because the strength of the credit, the strength of the cash flow, they'll be able to rapidly get back on their footing again. Have we gotten to the point where we can look at hybrid capital where that first call date is inside of five years? So in terms of call inside of five years, two out of three agencies are comfortable
with the concept. So that is a possible structure that issuers
can consider. There's one agency who is a bit more conservative on this view and want to keep the minimum non-call period at five years. But at the same time, that is the agency who has allowed make-whole features. So obviously, it may be more expensive to have a par call option, but at the same time, if the issuer has gone through M&A, it has went through tremendously well
and executed well, and they have provided meaningful credit improvement in executing the M&A, then issuers have an option to call the security before year five.
00:21:10:21 - 00:22:30:06
Yeah, and Moshe to your point, you talk about going shorter. Mizuho is of the belief that the more this product gets issued, you're not just going to see non-call five, non-call 10, non-call five, non-call 10 You're going to start to see this be more of a bond structure, because when you have, if you ultimately end up with four, five, or even six different tranches over time as an issuer of hybrid, you're going to want to diversify just like you do debt. So you could see people doing non-call five and 10, and then looking at is a non -call seven, is a non-call 12. Could I get to coupons where I want to lock that in longer than 10 years, much longer than 10 years? You know, we saw Vodafone do that trade a couple of years ago and locked in a perp non-call 30 at just over 5% tax deductible coupon. It's a fabulous trade for them when you look back at it right now. I think this market still has a lot of maturation to go through, and I think it's growing and the supply is going to keep it that way. It's going to push that envelope. But I think the point I'm hearing from all of you is the concept of hybrid capital has been there for many years. And what we've done as an industry is try to pigeonhole hybrid capital to
certain sectors and certain tenors from an issuance perspective. And it feels like that's all changing right now. And I think that creates more
opportunities and more flexibility for our clients.
00:22:30:23 - 00:23:43:05
You know, I think the one thing to also talk about, and I don't know if you want to go first or me, but the risks to this market, like what can stop the issuer side or in particular the demand side of the equation that we're seeing just tons of demand
for the product. But the question is, what can change that? I know from my... You know, Katie and I talk about this
all the time. From my standpoint, what I worry about is we're at historical subordination levels. We're at historical reset levels. Every issuer is looking at this right now in the last how many years and saying,
forget the supply. We are at the tightest spreads to senior debt that I've seen, and go back too far, I go back a while, is I've seen in my lifetime. I mean, how do you think about that with investors and their reaction? Like where do things get too tight? Well, I think we saw that in November, right, when we saw a ton of utility issuance. Pretty much every single day, a different name was in the market and people are trying to triangulate fair value. So I think it's, you know, supply will be well absorbed. I'm confident in that. It's just a question of, to your point, at what level? And I think rate fall plays into that.
00:23:43:23 - 00:25:00:20
I think, you know, obviously with
the new administration's funding plans of funding the deficit, we will probably see higher rates if you speak to our economist, Steve Ricchiuto, and this is a rate product. This is a coupon product. And so, you know, if we go up too fast, I do think that you will see some volatility in that and you'll see the
premiums go up. But because of the amount of cash on the sidelines, and I think because it is a rate product, ultimately, I think we just shift a little bit higher. And I do think as of now, premium does solve the supply question. And I think it's manageable at this
moment in time. And we didn't even touch on the applicability of this in the high-yield market, but I guess that's a topic for a different session. I want to thank Jee-Won, Katie, and Victor for joining us. Again, we wanted to bring you up to date on that market. It is a market that we think is going to expand in scope. It's a market that we think is going to be that much more applicable given our expectations on M&A So, hopefully, we’ve addressed some of the basic questions on hybrid securities, but most importantly, talk to you about exactly what is the art of the possible and what that can mean for next year. Thank you very much. Thank you.