A new breed of hybrid, contingent convertibles are bonds that behave like equities but pay interest like bonds

By Andrew Allentuck | February 2014

Hybrid bonds, which are deeply subordinated debt issues with tantalizing interest rates of 8% a year or more, have hit the market. But these potentially rich returns come with a significant amount of risk.

For example, clients holding hybrid bonds get no certainty of payment of interest, no enforceable guarantee of repayment of principal and the possibility that in a liquidity crisis, bank regulators could force bondholders to "bail in" the issuing banks. That's because these bonds would be classified as "regulatory capital" and then be converted to common equities at unknown values.

These new bonds, also called "contingent convertibles" - CoCos, for short - can be converted to equities to boost the issuing bank's Tier 1 capital. In structure, hybrids are like equities, which means that these bonds don't add to balance-sheet leverage as conventional bonds would. But because hybrids are fixed-interest devices, the interest payments are a pre-earnings cost rather than a dividend-like sharing of earnings.

To date, 23 billion euros worth of CoCos have been issued in Europe in 2013, according to Royal Bank of Scotland, which tracks these hybrids. The hybrids convert to common stock if the issuer's regulatory capital drops below 7% of total assets. Thus far, banks are the main issuers, although large utilities firms have issued hybrids as well.

One of the most recent hybrids is the Barclays PLC 8.25% bond that was issued on Nov. 20, 2013, at $99.99. This US$2-billion issue is a perpetual with an 8.25% coupon. This bond has a five-year call on Dec. 15, 2018, and carries a subinvestment-grade rating of BB+ from Fitch Ratings Ltd. This bond has been an active trader, with a recent price of US$102.50.

With banks searching for more capital to meet the new Basel III regulations, these hybrid bonds shift bank capital risk to bondholders who take the chance that they might have to sacrifice their money if needed to "bail in" the issuing bank during a crisis. Hybrids add to the total debt that the issuer has to service, although they offer a way out if the bank wishes to convert them to equities.

Those clients who hold the Barclays' issue, much like others who invest in CoCos, are in a curious position: they hold bonds with no guarantee of payment, no maturity date and a call that the bank can honour - or not - and equity with scant upside if issued in a capital crisis.

"I would not buy a hybrid bond right now, "says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto. "There's not only the question of how these bonds would behave if an issuing bank were stressed [by] trying to meet rules for regulatory capital, but you also don't know precisely how the conversion trigger would work. If the issuing bank needs more regulatory capital, the bondholders' money can be converted to equities at a time when the bank is in trouble. [This would] not a good time to be forced into a bank's common stock, [although it] might recover, of course."

Each issue of hybrids has unique bells and whistles. For the Barclays issue, for example, the buyer gets a 560-basis-point (bps) pickup over the 10-year U.S. Treasury bond. In comparison, the Bank of America Merrill Lynch master II high-yield index has a 375-bps spread over the 10-year U.S. T-bond. That CoCos have a far wider spread reflects the market's appraisal of their risk.

"CoCos are really equities dressed up as debt," says Paul Sandhu, vice president and director of Marret Asset Management Inc. in Toronto. "And the yield and risk are at equities levels."

Thus far, hybrids are mostly European issues aimed at U.S. investors. But Canada may create its own form of hybrid bond, which would technically be called "non-viable contingent capital" (NVCC, for short), which would work the same way.

If Tier 1 capital of the issuing bank were to drop below 7%, the federal finance minister would apply these bonds to capital to repair the bank's Tier 1 capital ratio and leave the NVCC holders with shares in the bank, explains Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto.

There is a precedent for NVCCs. Ten years ago, the chartered banks issued bonds with limited creditor rights that could be converted to preferred shares. For example, Royal Bank of Canada (RBC) sold "trust capital securities," or TRUCS. Labelled as preferred securities, they were bonds that were convertible to preferreds if RBC needed to downgrade its obligations.

The question, in the end, is what these new hybrids truly are.

"They can call these bonds Tier 1 capital, which is equivalent to common equity," says James Hymas, president of Hymas Investment Management Inc. in Toronto, "but [the bonds] get a better or more efficient treatment of the cost on income statements. A lot of portfolio managers will buy them because they have a mandate to invest in bonds, and these hybrids meet the definition of a bond and have terrific interest. Clients may be naive enough to accept these hybrids for their portfolios. But what clients forget is that in exchange for a yield pickup of a few hundred basis points over other corporate debt, a loss could approach 100%."

In the search for yield, hybrids are the latest twist in the old idea of compromising the promise of a traditional bond to pay interest and principal on time, Hymas adds: "Many of these structures will go into bond indices. Index funds would have to buy them and some fund managers would then have to take them on, too.

"I would not be averse to buying them," he continues. "But I would do it for a bond portfolio, which the client fully understands and accepts."

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