Although the majority of bond issues are straightforward debt sales, alternatives are available. Hybrid bonds combine features of bonds with those of equity, providing accounting and regulatory advantages for corporates in particular situations.

Typical features

In contrast to straight debt or equity instruments, hybrid bonds contain elements of both.

They are flexible instruments, encompassing a range of characteristics, typically including at least some of the following features. It is important to note that securities laws vary across jurisdictions, and these features should be viewed as typical rather than binding in all cases.

• Maturity.

  Hybrid bonds often have very long maturity dates, or even no maturity date at all, and are typically callable by the issuer. Often, the investor is made aware of possible call dates but the issuer may choose to roll over (that is, not call) the bond at the first possible date, instead choosing to wait. The indeterminate maturity of these instruments is one equity-like characteristic.

• Coupon step-up.

  If the bond is not called at the first possible date, the coupon may be increased. Such a clause is usually included to protect the lender, who has a strong interest in the bond being paid back at the first possible date.

• Subordination.

  Hybrid bond investors absorb relatively high levels of loss in the event of a bankruptcy as the bonds are deeply subordinated to senior debt and are senior only to equity. Investors therefore demand higher yields versus straight bonds of the same maturity for the same issuer.

• Mandatory non-payment of coupon.

  An essential equity-like feature of hybrid bonds is the possibility of deferring or not paying the coupon. This is similar to equity as dividends can also be deferred while deferring an interest payment on a straight bond is treated as an event of default. For hybrids, non-payment can be either mandatory or optional. Mandatory non-payment clauses can prescribe, for example, that if the company does not meet specified financial ratio tests the coupon payment is halted. These tests might include set ratios of cash flow to sales, cash flow to debt or net interest cover.

• Optional non-payment of coupon.

  Despite its name, ‘optional non-payment’ does not mean the issuer can freely choose whether or not to pay the coupon. Rather, it means if a company pays a dividend or buys back its own shares it will first have to pay the coupon. Depending on the structure of the hybrid, if coupon payments are not made, these payments may have to be accumulated for a specified number of years and paid at the end of that period. However, hybrids are flexible instruments. An alternative way of structuring the bond is to draw it up in a ‘non-cumulative’ way – that is, unpaid coupons do not have to be paid at a later stage.

The pros and cons

Key to the issuance of hybrid bonds is the regulatory position of the instruments. They are treated as debt for tax purposes and – because of their very long maturities – sizeable proportions of the bond are treated as equity for accounting purposes, under IFRS rules.

This brings benefits to the issuer. Interest payments are tax-deductible, and so treating the hybrid as debt lowers tax costs. This contrasts with dividend payments on equity, which are taxable.

The partial treatment as equity is also beneficial. Equity is not factored into certain ratios – cashflow to debt, for example – so treating hybrid bonds as equity can improve a company’s credit rating.

Indeed, this technique is explicitly approved of by the ratings agencies. Moody’s highlighted the growing popularity of hybrids as far back as 1999, describing the bonds as ‘a low-cost alternative to equity financing’. The agency launched its ‘Tool Kit’ that year, giving hybrids a grade from ‘A’ to ‘E’. On that scale securities rated ‘A’ are the most debt-like and those rated ‘E’ are closest to equity. For example, those closest to debt may be ‘perpetual preferred securities with a five year cash call if they are issued by high grade corporate issuers’, and those most like equity are ‘mandatorily convertible preferred stock’, according to Moody’s guidelines.

The way in which hybrids were rated was changed in the issuers’ favour in 2005 as it became clear many hybrids were not fully permanent structures. Moody’s changed its measurement strategy to reflect the increasing frequency of cash calls on the hybrids as the market became more dynamic. That change made hybrids look more like traditional bonds. At the same time the agency recognised that yield deferrals did not necessarily mean a greater likelihood of defaulting, instead treating such a deferral in the same way as a reduced dividend – thus viewing hybrids in a similar light to equity.

These similarities with equity mean that the debt has a lower impact on the corporate’s credit rating than traditional debt. This can be particularly important when refinancing debt – a hybrid can be issued to pay off an existing bond and improve the company’s debt position at the same time. Changing the rating strategy to better reflect the ways in which companies use hybrids has been seen as a core reason for the instruments increase in popularity since 2005.

As an extra benefit for financial institutions, regulators tend to treat hybrid securities as equity, contributing towards tier 1 capital requirements.

However, there are costs associated with hybrids, too. Foremost amongst these is the coupon paid – the extra risk and lack of certain repayment dates means investors seek a higher yield than they would on a similarly dated normal bond.

When are they appropriate?

In the low interest rate environment that we are currently experiencing – and bearing in mind the likelihood of rates rising in the near future – treasurers must have a good reason for choosing to pay the premium inflicted by a hybrid.

• Debt refinancing.

  Because of their equity-like characteristics, hybrids can be used to refinance debt to improve the company’s books. For example, Belgian pharmaceuticals group UCB issued a €300m perpetual subordinated bond in March. The company described it as ‘a very clever further optimisation of our capital structure as we can treat it as equity under IFRS’.

• Acquisitions.

  Similarly, corporates can finance acquisitions with hybrid bond issuance, knowing that the acquirer’s credit rating will suffer less than if a straight bond were issued. Further, equity is not diluted by the move. Tata Power, for example, issued a $450m hybrid bond in April, saying it would be used both to refinance earlier debts and to fund acquisitions. As leverage is not increased by hybrid bond issuance, corporates still have room to raise additional funds via a straight bond should circumstances require it.

• Share buy-backs.

  As with acquisitions, financing share repurchase programmes with hybrid bonds reduces the impact on the firm’s leverage.