Introduction

There has been much debate recently about hybrid securities in the debt capital markets. Are they an attractive long-term investment and sound borrowers' product, or a passing trend in the non-financial corporate arena? This five-part series answers this question and provides treasurers in dynamic and capital-hungry entities with a thorough understanding of the attractions, flexibility, myriad features and risks of hybrid securities.

Hybrids are currently a hot topic. Rapidly increasing issuance across industry and geographical sectors, major regulatory developments and the close attention of the credit rating agencies have combined to place hybrids at centre stage of the global capital markets.

Issuance runs into hundreds of billions of dollars. And hybrids are no longer an exotic or specialist asset class used primarily by regulated financial services issuers. Rather, they have become a distinct and ascendant asset class and a major global source of capital.

Hybrids demand - and reward - the serious consideration of all capital-hungry entities as a flexible and attractive potential alternative, or complement, to either straight equity or straight debt.

In this environment, and with corporate issuance experiencing the most rapid expansion, it is crucial for corporate treasurers, in particular, to be aware of the principles and issues involved.

Definition

Hybrids combine both equity and debt characteristics with the objective of providing manageable, non-dilutive and attractively priced capital.

• Equity, crucially, has no maturity, obligates the issuer to no fixed periodic payments and is the most at risk and lowest ranked of all securities. As a consequence, equity may be relatively expensive and cumbersome to raise and service but provides significant financial flexibility to an issuer and, in particular, the ability to generate leverage.
• Debt, by contrast, has a defined maturity structure, accrues interest and is ranked senior to equity.
• Hybrids, meanwhile, are defined as subordinated bonds with some equity characteristics, such as perpetual or very long-dated maturities or an absence of obligatory fixed period payments.

Flexible Equity/Debt Characteristics

Hybrids, for all their current fashionability, are not a new phenomenon. So, for example, preference shares, that traditional staple of UK corporate finance, are a form of hybrid. Preference shares count as equity but are generally non-participating and entitle the owner to a fixed dividend even if dividends are not paid to ordinary shareholders. They are also usually cumulative, with unpaid dividends in any one year carried forward. They may also be redeemable or convertible.

The contingent nature of preference shares' characteristics - 'generally non-participating', 'usually cumulative', 'may also be redeemable or convertible' - underlines the fundamental flexibility and variability of all hybrids.

Hybrids are located across a broad spectrum, whose extremes are defined by the starkly contrasting characteristics of straight equity and debt. Across that spectrum, the characteristics of individual hybrids vary significantly. This flexibility allows individual hybrids to exhibit either equity or debt characteristics in relation to specific variables - maturity, deferability of payments and seniority - and to do so to greater or lesser extents.

This striking feature of flexibility and variability offers attractive, bespoke possibilities, especially to potential issuers and fee-earning investment bankers. Alternatively, it may be viewed as unattractive or risky non-standardisation, especially by sceptical and hard-pressed investors.

An Attractive Source of Capital

Ultimately, of course, both equity and debt are generally represented in the balance sheet of a mature and rational issuer, with an eye on the interests of shareholders, the purposes to which capital is to be applied, to diversification among classes of capital and investors and to the initial costs of issuance and to the continuing post-tax cost of servicing capital.

Shareholders' equity undoubtedly lies at the very heart of corporate identity and the balance sheet. It offers maximum flexibility and the capacity to generate leverage. Debt, meanwhile, is invariably cheaper to issue - and to continue to issue periodically and opportunistically - and also entails a lower post-tax cost of capital.

Hybrids offer a possible Holy Grail of equity flexibility and absence of obligation or increased gearing, with the non-dilution and lower post-tax cost of capital offered by debt issuance.

It's a Holy Grail that issuers and investment bankers have, inevitably, pursued with considerable enthusiasm.

Regulatory and Market Developments

The emergence of hybrids owes at least as much to regulatory developments across jurisdictions as it does to the ingenuity of issuers and investment bankers. And at least as much again to the evolving methodologies of the credit rating agencies, which are considered below.

Financial Institutions

The initial impetus for the recent ascendancy of hybrids dates from the Basel Accords and regulators' endeavours to determine and enforce capital adequacy standards, defining core (Tier 1) and supplementary capital (Tier 2).

In 1996, the US Federal Reserve approved the inclusion of trust preferred securities in Tier 1 capital, up to a limit of 25 per cent of Tier 1 capital. Prolific US bank issuance of trust preferred securities followed in 1996-97.

In late 1998, the Basel Committee amended its definition of Tier 1 capital to include 'innovative' forms of capital up to a limit of 15 per cent, opening the way to the inclusion of hybrids, instruments that were treated as non-cumulative preference shares for capital adequacy purposes but that were still tax-deductible in parallel with debt securities.

In Europe, the introduction of the euro, along with significant industry consolidation across the continent, provided further impetus to acquisitive, capital-hungry banks' issuance of hybrids.

As a result of strong corporate demand for capital, financial market ingenuity and regulatory innovation, between 1996 and 2004 global hybrid issuance approximated US$250bn and annual issuance has simply continued to accelerate in the past two years.

Further impetus, beyond issuers' demand for capital, has been provided by the Federal Reserve's regulatory interpretation that allows bank holding companies to issue 'mandatorily convertible securities' that convert into preferred stock. With perhaps US$50bn of earlier trust preferred securities likely to be refinanced in accordance with the new interpretation in the next year or two, the implications for the burgeoning market are clear.

Regulators intended that such hybrids should absorb losses, such as equity, while issuers and investors often considered such securities to be more like debt. So, for example, trust preferred securities, first issued in 1993, were deliberately structured in order to be treated as equity for financial statement purposes and as debt for tax purposes.

Such discontinuities, both of perception and of substance, conferred significant potential risk. The interposition of the credit ratings agencies provided an analytical framework to handle these discontinuities and thus contributed significantly to underpinning the viability of the emerging hybrid asset class.

Insurance Companies

As with the banking sector, hybrid issuance by insurance companies reflects the sector's burgeoning appetite for capital and has also been facilitated by regulatory initiatives. Solvency II, for example, will align insurance capital requirements more closely with those of the banking sector across the EU and should underpin further buoyant hybrid issuance by insurance companies in the next year.

Banks and insurance companies have now issued hybrids in US, Australian and Singaporean dollars, sterling and euros, with additional Tier 2 issuance in New Taiwan and Canadian dollars, Swiss francs, Norwegian krone and Japanese yen. The asset class and market have become truly global.

The Corporate Sector

Corporate hybrid issuance is the most recent major market trend. Such issuance is generally tax-deductible, non-dilutive and may reduce the issuer's weighted average cost of capital.

Hybrid issuance within the non-regulated corporate sector is expanding, albeit from a narrow base, more rapidly than in either the regulated, banking or insurance sectors. And while hybrid issuance in the financial sector was initially more pronounced in the US than in Europe, the opposite is true for corporate issuance, with Europe developing more rapidly than the US. However, in 2005 euro-denominated hybrid issuance by financial institutions, by value, remained around five times that of corporate issuers.

Corporate hybrid issuance has been driven chiefly by buoyant levels of M&A activity. Corporate issuance represents a viable alternative to raising equity or debt, or to disposing of other assets. In some cases, hybrid issuance has allowed an acquisition to proceed without a detrimental impact on the acquirer's credit rating and certainly without the dilution of major shareholders' equity. Major shareholders in this regard may be the family owners of private companies or, indeed, governments.

Corporate hybrid issuance may also finance share buy-backs or enhanced dividend payments without materially increasing an issuer's leverage. It may also be issued specifically to finance pension fund deficits, or to reduce debt and to de-leverage the issuer.

Corporate issuance in euros in the past year has been buoyant with all of these factors underpinning one or more of the major issues to have been undertaken.

Credit Where Credit's Due

The commitment of the credit rating agencies to developing methodologies for assessing the credit quality of hybrids has been crucial to the development of the asset class, especially in respect of the non-regulated corporate sector. And the relationship between an actual or potential issuer and its agency(ies) is just as important in respect of hybrids as with all other rated issuance.

Issuance

The credit ratings agencies have been active since the introduction of hybrid securities, evolving alternative methodologies for assigning equity credit to hybrids. However, the majority of early issuance was designed to meet regulatory requirements rather than to satisfy the credit concerns of the agencies.

In 2001, Fitch published guidelines for allocating equity equivalence across a spectrum of hybrids. These guidelines reflected a particular concern with the cash flow flexibility any one hybrid allowed an issuer during periods of stress.

In 2004, more than 200 hybrids with a total value approaching US$50bn were back-tested to assess whether their performance in a period of financial stress was consistent with the Fitch guidelines for equity allocation. This analysis revealed that some hybrids successfully provided equity-like flexibility, or loss absorption characteristics but that others were less effective in this regard.

Major conclusions include:

• Issuers in financial distress either restructured and solved their problems within three years, or liquidated;
• Securities with more than 10 years to maturity, without the right to acceleration, provided substantial liquidity relief and thus full, 100 per cent equity credit is assigned to a security with a maturity of more than 10 years, reducing to 0 per cent at five years to redemption; and
• Equity credit is reduced or even eliminated for hybrids with financial covenants similar to senior debt or that would represent a senior claim against the issuer in the event of bankruptcy.

Fitch has just published a consultation document on a new hybrid securities methodology. The market for these securities has developed, as noted, recently. This development has been accompanied by requests for a simplified approach to equity credit allocation, with a degree of standardisation of rating agency approaches desired. The consultation document therefore specifies that Fitch uses five classes of equity allocation between 0 and 100 per cent, with Class A permitting 100 per cent equity allocation for a hybrid security, class B 75 per cent and thereon down to Class E's 0 per cent.

The Fitch Equity-Debt Continuum extends from 100 per cent equity credit for common stock to 0 per cent equity credit for straight debt or for preferred stock with an investor put feature, or for optionally convertible senior debt that is either out of the money and/or with several years to its call date. Between these two extremes, factors and securities are carefully assessed for equity credit.

In addition to the activities of the credit ratings agencies, accountancy regulations have also evolved to account for hybrids, with IAS 32 classifying nearly all hybrid securities as debt.

Investment

Investors have also generally been persuaded of the viability of hybrids. Underperforming equities and low interest rates, in conjunction with regulatory changes, have generated appetite for such securities. Investors are concerned that hybrid issuance should be underpinned by a viable business case and there are residual concerns relating to the non-standardisation of such securities across and within jurisdictions but documentation and technical issues are being rendered consistent, as far as possible.

In parallel with the work of the credit rating agencies, investment banks have developed sophisticated valuation models that have especially supported investor interest in the asset class.

Conclusion

Hybrids are set to remain centre stage. Favourable regulation, the close attention of the credit ratings agencies, the appetite for capital by issuers and for yield by investors and standardisation within the asset class are all set to ensure continued buoyant levels of issuance.

For corporate treasurers, the attractions are clear and include flexibility, minimal impact on gearing, non-dilution, tax-deductibility and reduced weighted average cost of capital.

The second article in this guide to hybrid securities will look more closely at developments and issues within the burgeoning corporate hybrid sector.

Article by Fitch, the international rating agency