Dec. 21 (Bloomberg) -- Hybrid bond sales are accelerating as a growing number of debt investors seek higher yields and protection from leveraged buyouts, which damage credit ratings.
(Note: Hybrid bonds, or Baby Bonds issued in denominations of $25, can be found in PreferredsOnline, www.epreferreds.com).
About $26 billion of hybrids, securities that have characteristics of debt and equity, were sold in the last four months, or 40 percent of this year's $65 billion total, according to data compiled by Lehman Brothers Holdings Inc. Hybrid sales climbed 55 percent from 2005's issuance, Lehman data show.
Investors are buying hybrids sold by New York-based MetLife Inc. and Seattle-based Washington Mutual Inc. because the securities offer yields that are 1 percentage point above senior unsecured securities and the companies are unlikely targets for takeovers that would pile on more debt.
``There is considerable investor appetite to reach for yield in sectors that have relative immunity to leveraged buyouts,'' Edward Marrinan, head of North American credit strategy at JPMorgan Chase & Co. in New York, said in an interview.
Demand for the debt is so strong that JPMorgan, the third- biggest U.S. bank, this month created indexes to track their performance and started a research publication on the securities, Marrinan said. Sales of hybrids will increase by about $10 billion to $80 billion in 2007, he said.
Financial institutions sold more than 75 percent of the hybrids this year, Lehman data show. Banks aren't typically considered likely LBO candidates because they are regulated by the government and their business depends on maintaining top credit ratings. In an LBO, firms typically borrow two-thirds of the money they use for acquisitions, increasing debt loads and lowering credit ratings.
Bondholders have suffered more than $2 billion of losses in 2006 as private equity firms announced a record $657 billion of takeovers, data compiled by Bloomberg show.
`Good Vehicle'
Marrinan forecasts hybrids bonds to gain more than regular debt next year. The extra yield, or spread, investors demand to own hybrids instead of Treasuries may narrow by 20 basis points in 2007 from 132 basis points, while investment-grade bond spreads may shrink by 7 basis points from 82 basis points, Marrinan said on Dec. 18. A basis point is 0.01 percentage point.
``We think they've been a good vehicle and very undervalued for a long time,'' said Gregory Habeeb, who manages $6.25 billion of bonds at Calvert Asset Management in Bethesda, Maryland. ``As they've become more popular, they've become more dear and they've rallied substantially.''
Habeeb said he's bought ``almost every'' hybrid offered, including those sold by MetLife and Minneapolis-based U.S. Bancorp, which issued $500 million of 6.091 percent perpetual debt on Dec. 18.
Hybrids offer higher yields because they rank behind senior bonds for repayment in a bankruptcy. Issuers can defer interest payments without defaulting, and the securities may have no maturity, similar to preferred stock.
MetLife's Sale
MetLife, the biggest U.S. life insurer, sold $1.25 billion of the securities on Dec. 14 in the biggest hybrid offering by an insurer this year, according to JPMorgan.
The debt pays 6.4 percent interest until December 2036, when it may be redeemed. After that it pays floating-rate interest of 220.5 basis points more than the three-month London interbank offered rate. Libor, a lending benchmark set daily by banks, is 5.37 percent.
MetLife's hybrids are rated A3 by Moody's Investors Service and BBB+ by Standard & Poor's, four and five levels lower than the $400 million of 5.125 percent five-year debt it sold on Nov. 2. The hybrids have risen about 2 cents to 102 cents on the dollar, according to Trace, the bond-price reporting system of the NASD. The spread has narrowed to 153 basis points from 170 basis points, Trace data show.
More Demand
``The cheapness is disappearing because there's more participants, and when there's more demand things can't remain cheap forever,'' Calvert's Habeeb said. ``The fact that spreads have come in as much as they've come in makes it attractive for the issuer.''
Hybrids have returned 209 basis points more than Treasuries in the last three months, compared with 52 basis points for investment-grade corporate bonds, according to a Lehman report published on Dec. 19.
The institutional market for new hybrids was shut down for almost two months after the National Association of Insurance Commissioners, a Kansas City, Missouri-based group of state insurance regulators, ruled in March that hybrids issued by Lehman should be classified as common stock. In September, the NAIC decided to temporarily classify the securities as preferred stock, spurring a rally.
``We view the market as having been well tested by the year's events, and relative performance has been exceptionally strong over the past several months,'' Marc Pomper, a credit strategist at Lehman in New York, said in the report. ``We expect continued, but less dramatic, outperformance in 2007.''
`Exotic Flowers'
Issuers like hybrids because they can pay interest with pre- tax profits, unlike dividends, and the rating companies don't count all of the money borrowed as debt on their balance sheet. S&P said it will treat MetLife's hybrids as 100 percent equity.
More companies are selling hybrid bonds with similar maturities, interest rates and redemption schedules, which should fuel sales in 2007, said Ellen Lapson, an analyst at Fitch Ratings in New York.
``A year ago there seemed to be a lot of different exotic flowers blooming,'' Lapson said. ``Investors don't feel comfortable when the terms of each security are so different. We've already seen quite an improvement in the structures in terms of standardization.''
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