Mythbusters

During the past two days, there have been two articles, one in the Wall Street Journal and one on Bloomberg News discussing so-called "hybrid securities" The mention of hybrids has causes some investors to believe that the articles were referring to trust preferreds or even straight preferred equity. Let's cut through the haze.

Let's discuss the Wall Street Journal article. After reading it twice, it made little sense to me. The author first makes reference to the $700 billion hybrid market. That would have to include the trust preferreds. However, the relevance to the $25 par preferreds with which we are familiar ends here. The author mentions investor dismay that these hybrids were not retired "when expected" Since he mentioned perpetual hybrids, this posed two questions: 1) Since most $25 trust preferreds (hybrids) have maturities, what his he talking about? 2) If they are perpetual the only way they can be retired is by the issuer calling them in. Fixed income 101 states that one should never count on a call be exercised. Fixed income 205 says that an issuer will only call a security if doing so is advantageous for the issuer. Given the current credit markets environment, I could not imagine an issuer finding an advantage of calling in a security unless its coupon was so high that refinancing at today's rates offered a cost savings. My curiosity got the best of me so I contacted the author, Neil Shah or the Wall Street Journal.

Mr. Shah was happy to answer my e-mails, but what he told me made me concerned that those reporting on more esoteric securities have little understanding of their markets. The first thing I did was ask Mr. Shah to offer an example of a hybrid security which investors expected to be called. They security he used as an example as a Deutsche Bank 1,000 euro perpetual hybrid (yes, it is euro denominated), 3.875% due 2014. My eyes nearly popped out of my head. How could anyone in their right minds believe that a bank which would need to offer a five-year bond of at least 6.00%, if not higher, in today's environment call in a hybrid with a 3.875% coupon? Mr. Shah insists that investors expected this security and others like it to be called. My colleagues and I would be anxious to be the other side of these investors' trades. We could probably make a nice living this way, albeit for a short period of time as they would soon run out of capital. Mr. Shah also insisted that similar securities (with similar coupons) have been called in during the past year. Skeptical, we looked into this. We could not find an example. Mr. Shah couldn't or wouldn't offer examples. This myth was busted.

Today, Bloomberg News discussed hybrids. Although the securities discussed by Bloomberg are more closely related to the more familiar $25 trust preferreds, the article was about a different kind of structure.

The Bloomberg article discussed how hybrid securities may stop paying interest if a bank was nationalized. The securities being referred to are $1,000 trust securities. These are essentially trust preferreds which trade and look like corporate bonds. As with $25 trust preferreds, they are kinds of junior subordinate debt. The article is correct that in the case of a nationalization, hybrid interest payments could be stopped. They could be stopped permanently. They could be stopped temporarily. However, this could be true of straight preferreds (non-cumulative preferred equity), common shares and even senior debt.

In the case of a nationalization, the government could force what is known as a cram down. A cram down results in investors receiving less than par for their securities. The more senior one's securities are, the more one will receive. In the case of a cram down, investors have little recourse but to take what they get. Trust securities will always fair better than common and preferred equity and will always fair worse than more senior debt. The article was right to express concern over the treatment of trust securities in the case of a nationalization, but it should have mentioned that more subordinate securities are even more vulnerable.

The Bloomberg article, although not really false, appeared to foster a myth that hybrids were especially vulnerable to a nationalization. In actuality, non-cumulative preferred equity and common shares are even more vulnerable and even senior debt is may not be immune. The bottom line is that if one thinks that a true nationalization is possible for a bank, one should look elsewhere for investment opportunities. Although the nationalization of troubled banks is possible, it is an action of last resort as it would be expensive and cumbersome to seize a large bank. I would have to say that the myth that hybrids are an especially vulnerable asset class has been busted.