Hyping hybrids

Can Wall Street help companies raise capital more efficiently by splicing the genes of stocks and bonds?

Fuel-efficient cars aren’t the only hybrids getting attention these days. On Wall Street there’s growing interest in crossbreeds of another sort -- securities that combine elements of equity and debt to help companies raise capital cheaply.

Following a change last year in rating-agency policies, investment banks have put a new twist on a popular form of debt-equity hybrids known as trust-preferred shares. The new securities feature ultralong maturities of up to 60 years. Several financial services companies have issued them during the past six months. Nonfinancial issuers also are warming to the trend, prompting bankers at Lehman Brothers and Merrill Lynch & Co., two of the leading underwriters of these long-dated offerings, to estimate that issuance could reach as much as $60 billion this year, up from less than $5 billion in 2005.

“The financial sector has dominated issuance, but it’s applicable to any industry that wants to optimize the overall cost of capital,” says Jill Schildkraut-Katz, Merrill’s head of issuer product development.

The long maturities allow the securities to be classified mostly as equity on corporate balance sheets. Shorter-dated trust-preferreds, by contrast, have typically been considered 100 percent debt. (Companies create trust-preferreds by issuing bonds to self-created trusts and selling high-dividend-bearing shares of the trusts.)

Some companies that issue trust preferreds have significantly increased their debt loads and hurt their credit ratings. But in February 2005 bond rating agency Moody’s Investors Service announced that it would consider certain hybrids -- particularly those with maturities of at least 40 years -- 75 percent equity and just 25 percent debt. Underwriters soon began marketing long-dated trust-preferreds, noting that companies could enjoy the benefits of these securities -- chiefly, the ability to deduct interest payments on the trusts’ bonds from corporate income taxes -- without hurting their credit ratings. And since the equity portions aren’t considered common stock, earnings per share aren’t diluted.

But even though underwriters vetted their proposed structures with Moody’s (other rating agencies had already made similar adjustments, but companies were reluctant to act without Moody’s also weighing in) and with the Internal Revenue Service, no corporation wanted to be the guinea pig for the new securities. So Lehman, which had been considering a preferred stock offering anyway, broke the ice by selling $300 million of 60-year enhanced capital advantaged preferred securities in August. Because of the securities’ tax benefits, the deal cost Lehman several hundred basis points less than a preferred-stock offering would have, says Erin Callan, head of Lehman’s global financial solutions group.

Since then other companies have raised some $4 billion using long-term hybrids (see table). Most issuers have been financial institutions looking to raise cheap capital for regulatory purposes. Minneapolis-based U.S. Bancorp, for instance, had long issued trust-preferreds for this purpose. But the Moody’s ruling made the long-term structure more appealing. “It was the first opportunity to issue a security regarded as tier-1 capital that was tax-deductible and received higher equity treatment from the rating agencies,” explains Daryl Bible, the bank’s treasurer.

Nonfinancial companies have also been joining in. Railroad transport concern Burlington Northern Santa Fe Corp. sold $500 million of 50-year hybrids in December to fund its share-buyback program, for instance. But these hybrids aren’t for everyone. In November, New Britain, Connecticutbased toolmaker Stanley Works issued $450 million in 40-year trust-preferreds to help finance its $486 million acquisition of Facom Tools from French conglomerate Fimalac. Stanley Works’ securities have since traded at a discount to par. That may be because of market speculation that the company is a takeover target for private equity firms, which would pile on debt to finance a buyout and increase the risk of default or bankruptcy. (The company acknowledges the speculation but says that the hybrids have traded down because it got better terms at pricing than other issuers have.) If an issuer goes bankrupt, trust-preferred owners have less claim on assets than do holders of bonds or bank loans.

Hybrid happy

Industrial companies are starting to follow the lead of financial services firms in exploiting a ratings-agency ruling that makes issuing trust-preferred securities -- blends of stock and debt -- a more attractive financing option than it had been in the past.

Company

Date

Amount

($ millions)

Lehman Brothers

8/12/05

$300

Stanley Works

11/22/05

450

Zurich Financial Services

11/29/05

1,300

Reinsurance Group of America

12/5/05

400

Burlington Northern Santa Fe Corp.

12/12/05

500

International Lease Finance Corp.

12/15/05

1,000

U.S. Bancorp

12/29/05

375

Sources: Company reports; Moody’s Investors Service.

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