Cross-Dressing Securities

The new debt-equity hybrids look like the best of both worlds. But are they?

With corporate balance sheets as healthy as ever and stockholders clamoring for better returns, a big question for executives today is how to lever up to expand or to buy back shares without taking on too much debt. Erin Callan, a tax-lawyer-turned-investment-banker at Lehman Brothers Inc. (LEH ), thinks she has the answer in a new, custom-crafted variety of security that has Wall Street buzzing.

Known generically as enhanced trust-preferreds, these securities look like debt to investors and tax lawyers, who, for now, say companies can deduct the interest they pay out. Here's the thing: They also look like equity to credit-rating agencies and regulators, keeping bondholders happy. They're debt-equity hybrids, the ultimate two-faced securities. "This has the potential to redefine capital structures for Corporate America," says Callan. The deals are expected to boost earnings per share and stock prices for issuers and generate a ton of fees for underwriters.

They're certainly innovative. Hybrids make regular bond-like payments to investors. But unlike bonds, hybrids have exceedingly long maturities -- often 50 years or more -- which makes them essentially permanent capital, like equity. What's more, if a company's creditworthiness falls below preset thresholds, the bond-like payments automatically halt. But that doesn't trigger a default on the company's real bonds.

When times are good, hybrids offer the best of both words: fat yields for investors and favorable accounting treatment for companies. But when conditions change, these untested securities could offer the worst of both worlds: low returns, high risk, and angry investors.

Callan, 40, is among the most creative chefs, and last August her employer tasted her cooking. Lehman issued $300 million of hybrids at a floating interest rate, the deal that kicked off the market. Since then, other top investment banks have concocted their own variations, which they've issued for themselves and underwritten for clients. Citigroup (C ) brought out a $450 million, 5.9% issue for toolmaker Stanley Works (SWK ) in November, which the company used to pay for two acquisitions. Merrill Lynch & Co. (MER ) and Goldman Sachs & Co. (GS ) led a $500 million, 6.61% offering from Burlington Northern Santa Fe Corp. (BNI ), used to repay debt and fund share buybacks. On Jan. 25, Wachovia Securities brought the biggest deal to date, a $2.5 billion, 5.85% offering for its parent, Wachovia Corp. (WB ). These debt-equity hybrids have evolved to become "an unbeatable capital markets product" for banks and insurance companies, and might be used more in other industries as well, according to a report by Standard & Poor's (MHP ), the debt-rating agency that, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP ).


To be clear, hybrids are a terrible idea for individual investors. They're complex, idiosyncratic, and sometimes not even registered with the Securities & Exchange Commission.

But institutional investors are lapping them up. The appeal: With interest rates so low in the U.S. and abroad, fixed-income mavens are desperate for an extra half-point of yield and will take the additional risks these untested securities bring. More than 200 institutional investors bought into Wachovia's big offering, nearly 10 times the core group of investors that Wall Street had seen turn out for the less sophisticated trust-preferred hybrids of the past. "From all indications, this market is still in its infancy and will grow rapidly this year and into next year," says John Hines, a managing director and head of high-grade syndicate at Wachovia Securities.

Some $8.8 billion worth of hybrids have been issued so far this year, a rate that would produce around $52 billion of issues by yearend -- about 50% more than last year, when Callan and other investment bankers were still engineering the latest generation of enhanced trust-preferreds. This year some $30 billion of the previous generation of hybrids becomes eligible to be called back by the issuers, primarily financial institutions. They're all but certain to be refinanced with the new version, which offers lower interest rates, tax deductions, and new status as credit-enhancing equity capital by rating agencies and bank regulators, says John W. Dickey, head of global new products at Citigroup's investment bank.

Even for sophisticated investors, hybrids could be dangerous. They might well prove to be a product that flourishes only when the economy is strong, when investors are optimistic that issuers will prosper enough to redeem the instruments. Toss in a few high-profile defaults here and there, and investors will flee to the relative safety of bonds, which have stronger claims than hybrids in bankruptcy settlements.

What's more, as noted in offering statements, the hybrids' tax-deductibility to issuers is still just a matter of opinion from tax lawyers, not a definitive ruling by the Internal Revenue Service. Ditto accounting regulators, who already have their sights on overhauling definitions of debt and equity and accounting for trusts, which are used in structuring the securities. "You're always at the risk that the referees will change their minds," says David A. Hendler, a senior analyst at CreditSights Inc., an independent research firm.

In the meantime, Wall Street is looking at huge windfalls both as issuers and as underwriters. Hendler estimates that Citigroup, Wells Fargo & Co. (WFC ), and Bank of America Corp. (BAC ) could use the hybrids to fund share buybacks that would boost their earnings per share by 5% to 8% and, ostensibly, lift their stocks. What's more, based on the 2.5% underwriting commission on the Wachovia deal, Wall Street could generate $1.2 billion in underwriting fees for selling the securities just for the 20 top U.S. banks. Rating agencies, too, would pocket fees from evaluating the new issues.

Today's hybrids have grown out of decisions by regulators going back decades and out of instruments used by companies in Europe and Asia. Last year, two big changes hit that are driving today's deals. In February, Moody's Investors Service (MCO ), the debt-rating agency that had generally been the most skeptical of hybrids, issued new policies outlining when it would deem portions of an issue of hybrids to be equity. That meant companies could issue hybrids to buy back stock without hurting their credit ratings. Callan and competing investment bankers got busy engineering hybrids to meet Moody's tests for equity and IRS tests for debt expense.

Callan says she adapted elements from deals she had worked on overseas, where hybrids are more common and accepted by tax people. By August she and two other tax lawyers at Lehman had crafted the first hybrid to be issued with tax-deductible payments, terms appealing to investors, and 75% equity credit from Moody's. Other companies followed suit with similar deals.

The question is whether Callan and her competitors will be able to sell the structures to nonfinancial companies that don't constantly try to reduce their cost of money the way banks do. It has been tough so far. Most executives are reluctant to be financial pioneers, especially when they have to persuade their directors to go along. "You don't just pull these down off the shelf," says Citigroup's Dickey. "There are a lot of moving pieces." Secondary-market prices show that investors apparently have less confidence that nonfinancial issuers' hybrids will pay off as quickly as they want.

Still, money from hybrids may prove too cheap for nonfinancial companies to ignore. Callan calculates that the typical cost of hybrid capital tends to be about 4% after tax, compared with 12% for equity capital. With spreads like those, hybrids may be about to fly.

By David Henry

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