ING Investment Perspectives

February 21, 2012 ING M A RKE T PERSPECTIVES

Market Insight
Hybrid Capital: Going the Way of the Dinosaur?
Popular in the mid-2000s, hybrid capital instruments fell out of favor during the financial crisis as investors sought the relative safety of less-risky investments. Though hybrid capital has since recovered in value, changes in the regulatory environment are prompting an evolution in how these equity-like securities are structured. Below, we provide a primer on the history of the asset class and its potential future. What is hybrid capital? Why did banks issue it in the past? Hybrid capital instruments are bonds that allow the issuer Tier 1 equity credit while avoiding the dilution that would accompany the issuance of common equity. They also offer the issuer such desirable bondlike characteristics as interest expense deductions on a pre-tax basis. Financial leverage is increased while, paradoxically, regulatory capital ratios improve, other things being equal. Prior to the financial crisis, hybrid capital gave issuing banks access to the best of both worlds: better capital ratios without dilution plus tax efficiency. Bank returns on equity benefited as a result. Figure 1. Tier 1 Spreads Peaked in March 2009

Spencer Phua Senior Credit Analyst, U.S. Credit

Ryan Mitchell Analyst

Why was hybrid capital attractive to investors and to issuing banks? Which are the various classes of hybrid capital? Hybrid capital offered spread pickup in exchange for subordination over senior and regular subordinated bank notes. In 200507 a period during which credit spreads were historically low Tier 1 optionadjusted spreads were on average 47 basis points wider than senior notes. Also, hybrid capital was seen as a relatively attractive asset class because it allowed exposure to higher-rated banks with an attractive spread pickup; the rating on the hybrid capital was often only two notches lower than that for the senior notes. Little did investors know that hybrids would in a few short years become one of the most shunned asset classes of the financial crisis. By March 2009, the dollar price equivalent of the Tier 1 hybrid capital index stood at $42.50, a stark discount considering many such securities were issued at or near par (i.e., $100).

Hybrid Capital vs. Global Bank Debt Wides: Tier 1 OAS 2,336 bp, $42.50 Hybrid Capital Recovery: Tier 1 OAS 420 bp, $98.88

Option-Adjusted Spreads (Basis Points)

2,000 1,500 1,000 500 0

Between 2005 2007 Tier 1 OAS was 47 bp wider than bank debt on average

Global Bank Debt 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Barclays Capital Live

I N V EST M EN T M A N AG EMEN T

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During the Basel I regulatory regime, there were a few major types of hybrids including trust preferreds (TRUPS) and more recently issued forms of hybrid capital such as income trust securities and REIT preferreds. TRUPS were a class of long-dated (often 30-year), junior subordinated debt that was issued out of a special purpose vehicle (SPV) trust structure; hence the name trust preferred. Figure 2 illustrates the structure in generic form. Issuance started in the mid1990s. TRUPS did not get equity credit from the rating agencies, but received Tier 1 regulatory credit from U.S. bank regulators. U.S. banks issued TRUPS to boost their regulatory capital ratios without having to issue dilutive common equity. A number of newer hybrid structures issued in the mid-2000s improved on the TRUPS structure. These structures received rating agency equity credit as well as regulatory Tier 1 credit. The key feature that made them different from TRUPS (and that allowed them to receive rating agency equity credit) was a replacement capital covenant (RCC). Essentially, the issuing bank had to replace the security with another of equal or lower subordination in the Figure 2: Trust Preferred Securities Structure

February 21, 2012

event that the security was called. Because this was viewed as maintaining a layer of subordination below senior and regular subordinated debt beyond the call date of such a security, the rating agencies were willing to grant some equity credit to these structures. In addition, the legal final maturity of such securities was often longer than TRUPS some as long as 60 years or more from date of issue. There were many variations of such hybrids issued in 200507. Below we highlight two typical examples: income trust securities and REIT preferreds. The income trust securities structure involved a junior subordinated note issued by the bank to a trust, which subsequently issued junior subordinated debt to investors (as illustrated in Figure 3). After five years, the junior subordinated note would be remarketed, and the proceeds would be used to purchase preferred stock from the bank. Holders of income trust securities would thus eventually be investing in non-cumulative preferred stock. Wells Fargo 5.8% perpetuals are an example of such a security in the corporate bond market.

Issuer
Long-dated junior subordinated debt

SPV
Long-dated trust preferred securities

Investors

Source: JPMorgan

Figure 3. Income Trust Securities Structure

Issuance to Five Years Five Years and Beyond

Issuer
Junior sub-debt $ Callable preferred shares

Issuer
$ from remarketing to purchase prefs Floating-rate coupons

New or Existing Investors

Delaware Trust
Junior sub-debt

Delaware Trust
Floating-rate coupons

Investors

Source: JPMorgan

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The REIT preferred structure (as shown in figure 4) was initially issued by Washington Mutual for tax-efficiency reasons. Homeloan assets were held in a REIT structure while a subsidiary of the REIT issued preferred stock to investors that would be callable after five years. The income from the loan assets paid for the dividend on the preferred stock. The issuer (in this case Washington Mutual) Figure 4. REIT Preferred Securities Structure

February 21, 2012

obtained tax deductibility on coupon payments, avoided tax on the income from its home loans in the REIT and obtained regulatory and rating agency equity credit for issuing this security. Other banks issued REIT preferred structures as well; currently, U.S. Bancorp 6.091% perpetuals would be an example of such a security traded in the corporate bond market.

WaMu Structure Overview

WaMu Inc
Counts as core capital Receives regulatory and rating agency credit Provider of capital replacement covenant (critical) for rating agency treatment

Equity ownership

WaMu Bank

Assets Assets

Equity ownership

REIT

Tax efcient entity that absorbs preferred security coupon of LLC subsidiary in a tax-efcient format

Assets

LLC

Equity ownership

100% subsidiary of REIT Holder of mortgage-related assets Issuer of preference shares Non-taxable entity

Non-cumulative Perpetual Preferred

Trust

$ Non-cumulative Trust Preferred

Investors

Source: JPMorgan

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How have hybrid securities performed as fixed income investments over time? We noted above the yield advantage afforded by these hybrid securities at issuance. However, there has been regulatory and investor disillusionment with such securities during periods of economic and financial stress. From the regulatory perspective, hybrid capital was not good loss-absorbing capital compared with common equity because the majority of such hybrid capital securities did not have express principal writedown provisions. From an investor perspective, holders of such bonds were saddled with onerous markdowns in 200809, as these securities lost tremendous value due to the fear (sometimes justified) of coupon stoppages and regulatory enforced or encouraged writedowns or conversions into common stock. As explained above, the Tier 1 hybrid capital index dollar price suffered discounts of nearly $60 to par at its March 2009 wides. Slightly more than a year after this low point, in April 2010, the hybrid Tier 1 index reached $98. This represents a roughly 133% appreciation in price for a basket of fixed income instruments in only 13 months. We should note that this excludes the benefit of higher carry associated with these Tier 1 instruments; thus, total investment returns would be higher than 133% for a holder of a representative basket of Tier 1s during this period.

February 21, 2012

Suffice it to say that hybrid Tier 1 securities were the most volatile sub-segment of the already volatile banking sector during the financial crisis and the years that followed. Which of the recent regulatory changes have most affected hybrid capital? Due to the adoption of Basel III, most forms of previously issued hybrid capital will no longer count toward Tier 1 capital requirements. In general, bonds that were issued before September 2010 will lose 10% Tier 1 credit per year until called or the credit runs out. There are a couple of exceptions to this rule, one being bonds with step-up coupons; these will lose all equity credit once their call or step-up dates are reached. In the U.S., due to DoddFrank legislation, TRUPS will receive Tier 1 credit only until January 2013 but will be phased out completely by January 2016. We assume this will be done on a straight-line basis, although the pace is at the regulators discretion as we understand it. Bank regulators have placed greater emphasis on Tier 1 common/ core Tier 1 ratio as a means of measuring capital sufficiency. As hybrids are effectively excluded from Tier 1 common, their future role as regulatory capital instruments has waned.

Figure 5. Traditional Hybrid Structures Are Being Phased Out Due to Regulatory Changes
Basel III Timeline Tier 1 Hybrid Phase-Out

2013: 10%

2014: 10%

10% Annually Until Called

Dodd-Frank Timeline TRUPS Tier 1 Phase-Out

2013: Phase-Out Begins

2014: ?

2015: ?

January 2016: Phase-Out Complete

Source: BIS Publications/Dodd-Frank Wall Street Reform and Consumer Protection Act

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February 21, 2012

Current and future issuance in U.S. bank hybrid capital will be largely restricted to perpetual non-cumulative preferred stock. Recently, we have seen a number of high-quality regional banks issue preferred stock to boost their non-common Tier 1 ratio U.S. Bancorp 6.5% perpetuals callable in 2022 and PNC 6.75% perpetuals callable in 2021 were both issued in the last six months. Some European banks have issued a newer form of hybrid instrument known as contingent convertible securities (CoCos) that would allow Tier 2 credit initially but could convert to equity to boost core Tier 1 during periods of stress. These have not taken off to the extent their proponents first expected when we described them in May 2011 (see our article titled Will CoCos Save The Global Banking System?). This may have been due to investor risk aversion in the second half of 2011, but it is also likely because U.S. regulators have yet to provide clear guidelines on whether CoCos would receive regulatory approval in the U.S. Recently, UBS issued a tranche of U.S. dollar-denominated CoCos. How should we invest in hybrid capital? Based on their recent history, hybrid securities clearly represent a higher risk from a bond investors perspective. The securities have evolved from plain-vanilla TRUPS in the 1990s, to exotic variants in the mid-2000s, and are now back to traditional preferred stock. While their return profile is impressive compared with senior parts of the capital structure in improving market environments, the investment can be devastating in an environment of economic stress, especially if this coincides with a financial crisis. Given that hybrids are the asset class nearest to equities in terms of their risk/return profile, only risk-tolerant fixed income investors should invest in the asset class. As with any higher-volatility investment, picking the right entry point to set longs (or shorts ) will greatly influence performance. n

Figure 6. Basel III Is Changing the Definition of Capital Sufficiency

Current Tier 1 Common Tier 1 Non-Common Tier 2 SIFI Buffer Common and Preferred Stock Trust Preferreds and Hybrids Sub-Debt and Reserves Basel III Common Stock Preferred Stock Sub-Debt and Reserves Common Stock

Source: Barclays Capital

Some of these hybrid securities will become eligible for Tier 2 credit as subordinated debt. For securities like income trust securities that convert to preferred stock, they can become Tier 1 non-common instruments. In any event, from a banks perspective, the wonderful combination of tax deductibility and Tier 1 regulatory capital credit will not exist in the future. What is the outlook for hybrid capital going forward? We have noted multiple instances of hybrid capital instruments being called, tendered or exchanged recently. The issuing bank may be motivated to tender for such instruments to be repurchased below par, thus booking a gain on debt extinguishment in the process. To the extent that market participants and investors pay more attention to Tier 1 common/ core Tier 1 ratio now than before, lost equity credit from hybrid Tier 1s (i.e., non-common Tier 1) is of little consequence. Further, there might be an economic basis for banks to call such securities, even at par, if they can issue regular subordinated debt at lower spreads.

This commentary has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward looking statements that are based on managements current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. Past performance is no guarantee of future results.

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