Hottest Debt in US Market Creeps Into Development Finance

(Bloomberg) -- A type of risky debt that has taken US capital markets by storm in the past year is now emerging in bonds designed to unlock hundreds of billions in lending for the world’s poorest.

The offer of a 30-year hybrid bond on Thursday by the West African Development Bank marks a shift in the world of multilateral development bank financing by adopting a template that emerged a year ago. This type of hybrid debt — which shares characteristics with equity — has already taken off in the corporate world following a methodology change last February by Moody’s Ratings.

Funding efforts by supranational lenders are showing a progressive morphing from Additional Tier 1-style bonds to a simpler hybrid format that investors prefer. The latest African offering, described as an “innovative hybrid,” is part of efforts to raise $1.5 billion, some of it to finance green or social projects.

“The Moody’s template will eventually become the norm. It’s a win-win,” said Adrien Letellier, portfolio manager and head of fixed income research at Bordier & Cie. He pointed to advantages for both issuers and investors.

Such hybrids are subordinated bonds that give borrowers the ability to stop payments to conserve cash in difficult times, and they’re among the first assets to be wiped out when an issuer gets into trouble. Meanwhile bank AT1s are also subordinated debt, but have a number of extra bells and whistles to help comply with post-financial crisis regulations, so investors who don’t specialize in financials prefer the hybrid structure.

Ever since Moody’s changed its hybrid bond methodology a year ago to effectively boost the equity content, companies have been able to sell bonds with a set maturity, typically at 30 years from issuance, in order to pad their balance sheets and support their ratings.

US utilities became the biggest issuers, given tax advantages compared to the preferred shares they previously sold. In the process, they doomed the market for non-financial preferred stock — effectively killing a 200-year-old financing tool that helped industrialize the US. Now supranational lenders are taking up the baton.

The West African Development Bank, known by its French acronym BOAD, is set to raise $500 million from the 30-year junior bond that is callable after five years, according to a person familiar with the matter. By contrast, the first supranational hybrid deal from the African Development Bank was perpetual and only callable after 10 years, while a later issue by the Africa Finance Corporation added a step-up clause, a crucial departure from the AT1 model.

BOAD “should attract more interest from pure corporate hybrid investors than AfDB,” said Letellier. Demand from investors for the deal topped $1.4 billion, according to the person familiar with the deal.

The downside for BOAD is that the equity treatment won’t be as strong as in previous transactions by AfDB and the Africa Finance Corporation, according to Cesar Fernandez, a partner at Alpha Credit Advisors, a London-based emerging markets investor that is considering taking part in the deal. However, the overall capital increase will support BOAD’s metrics, he said.

Representatives at BOAD and BNP Paribas SA, the bank involved in both this offering and the AT1-like issue by AfDB, did not respond to requests for comment.

Pricing Benefits

With only a few supranational hybrids in existence so far, it’s still early to declare that a specific format has become the norm.

Still, each of those hybrids has taken the sector one step away from AT1s and closer to subordinated corporate bonds. And this could end up being reflected in the pricing of the latest issue. The yield was set at 8.5%.

“They’ve changed some key features, mostly to benefit investors,” said Fernandez. “Pricing should benefit from these new features.”