THERE IS AN old Wall Street bon mot that asks what you call a 50-year old investment banker. The answer is “a failure”. There is a London one that asks at what level of financial reserves an individual is “done”. The answer to that one is an amount that enables one to get divorced and still be “done”.
I failed on both counts. In fact, by the time you read this piece, I will be licking my wounds after yet another birthday. I might still be in the business (thanks, in part, to the matters related to the second question) but I certainly don’t feel that I have been a failure. Truth be told, I still thoroughly enjoy being part of the cut and thrust of the markets. Not every day, to be frank – but most days.
What I love about the job is the way in which one continues to learn. Take corporate subordinated debt.
I know my way around a bank’s balance sheet – having worked in the industry both at commercial and investment banks for longer than I care to remember, I have a decent idea of what makes the beasts breathe. I also have a vague idea of how corporates work, thanks to a stint as a credit analyst at a commercial bank in the 1980s.
But what I have never understood is why corporates issue subordinated paper. What, I have always wondered, is the purpose? In the case of banks the matter is transparent – but corporates?
What I have never understood is why corporates issue subordinated paper
PART OF THE privilege of age is that one can admit that there are things one doesn’t get without that becoming a career destroying event.
So it was that I called on a friend who runs UK DCM for a large European bank and asked him that very question. He instantly understood why I was perplexed and assured me that I had not misunderstood the capital structure issue – or, in the case of corporate hybrids, the lack thereof. It is, so he explained, a ratings agency arbitrage.
If a company is struggling to maintain its rating and the natural solution is to issue equity in order to shore up the capital base, then issuing subordinated debt is a cheap and easy option.
This has become the strategy favoured by ratings advisory shops. Sub-debt is miles cheaper than equity and non-diluting. It satisfies the ratings agencies and all is well in the garden. The added capital cushion keeps the downgrade risk at bay and the cost of funding a relatively costly hybrid is more than compensated for by keeping the cost of senior debt lower than it would be, should the credit rating be slashed. Meanwhile, investors get to buy corporate bonds at spreads that could only be dreamt of in the normal senior unsecured space.
THE FLY IN the ointment, according to my chap, is that in the end the hybrids work out for the issuers but not the investors. He reckons that once a company is on the slippery downgrade slope, it is normally due to either a flawed business model or flawed management. Pulling in subordinated debt only postpones the inevitable, by which time the investor base is limit-long the more volatile hybrid debt. He also suggested that the corporate treasurers tend to fall in love with the hybrid idea and are thus prone to over-issue such paper.
In the words of this friend, hybrids might look like a get-out-of-jail-free card but they aren’t really. They contribute nothing to the running of the company or to the strengthening of its output, productivity or profitability. At best, they provide a little breathing space.
And if the company gets downgraded below investment grade, the ratings benefit of sub debt over senior debt evaporates and the bonds risk getting called. ArcelorMittal taught us a ruthless lesson on that recently – although it was not money lost, just mark-to-market gains being taken back.
THAT SAID, QUITE a number of funds have made a killing by packing in high yielding hybrid issues and taking the pick-up over senior debt to great effect. There has to be some truth in the wisdom that by the time the sub-debt of some issuers defaults, it will most probably be one of the investors’ smaller problems.
Let’s face it, with very few exceptions, investors were not bitten by subordinated debt holdings in banks during the crisis – despite all their travails. Why should they fear that corporate subs should fare any worse?
Whoever said that you can’t teach an old dog new tricks has never been an old dog. On that subject I certainly can speak from experience.