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What are hybrids?

Hybrid securities are highly innovative financial products that fill the gap between senior debt and equity. Ranking between senior debt and equity in the capital structure, they can be redeemed by the issuer after a predetermined first call date. They have a very long or even perpetual legal maturity and feature coupon deferral mechanisms. Therefore, whilst enjoying tax deductibility on coupon payments, they share some of the features of equities, and therefore can be partially treated as such by rating agencies.

Who uses hybrids?

Hybrid securities used to be the privilege of financial institutions. They liked these instruments because they provide a convenient way of raising funds whilst maintaining regulatory ratios. However, following a landmark issuance by engineering group Linde in 2003, corporates have started using the flexibility offered by this instrument, thereby broadening the range of investment products available on the credit market.

While corporates do not face regulatory requirements as banks and insurance companies do, they may want to find a way to raise debt while maintaining their credit ratings. Moreover, some companies cannot, or may be unwilling, to issue shares, so finding a product that can act as a compromise between debt and equity is appealing.

Family-run and state-owned companies may also use hybrid debt as a substitute to equity issuance. Companies that want to avoid a rating downgrade or finance a wave of acquisitions are other likely users. From the investor point of view, senior investors may view issuance of hybrid debt as a positive as it gives issuers the flexibility to extend the maturity of debt and eventually miss subordinated interest payments, thereby improving the profile of senior debt.

So far, there have been seven hybrid issues by corporate companies targeted at institutional investors. Linde and tyre-maker Michelin were pioneers in 2003. Food group Sudzucker, energy companies Vattenfall and Dong, and healthcare firm Bayer came to the market in June and July 2005, and the most recent hybrid bond was issued by information services provider Thomson in September.

How do hybrids work?

In terms of maturity, all hybrids specify a first call date, typically 10 years after the issue date, when the issuer may redeem capital at par or face a 100bp step-up penalty. Most issues so far are perpetual. Two of them have a fixed but very long legal maturity; the Michelin issue is the only one to offer an initial 30-year maturity.

All hybrid securities give issuers the right to defer any interest payment, provided no cash has been paid to shareholders. Optionally deferred interest is cumulative in most existing issues. On top of the optional deferral language, a few hybrids include a mandatory deferral mechanism, by which interest is automatically omitted if a given financial ratio drops below a threshold. Omitted interest is non-cumulative.

As compensation for subordination, extension risk and deferral language, corporate hybrid issues offer a premium to senior debt. Hybrid spreads against benchmark typically trade at a three to four multiple against senior 10-year credit default swaps.

Investors can use hybrids as a simple way to increase carry while increasing exposure, or even to diversify by making a bet on 'exotic' extension or deferral risks. Moreover, these assets offer a way to play on long-term credit fundamentals, providing a useful complement to the market for long-term corporate bonds. Finally, they offer a way to take a position on subordinated debt against senior debt in case of a default.