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Hybrid Securities / Hybrid Debt / Subordinated Debt

Investment bankers like to toss around “hybrids” as a funding feature. Hybrids come with higher Debt Capital Markets issuance fees than straight bonds and are a great way to earn league table credit.

Key things for Hybrids:

  • Considered equity by rating agencies (otherwise pointless to pay more interest)
  • Not dilutive to equity (no ownership or voting rights and claim on common dividend)
  • Subordinated/very junior debt and senior only to equity/preferred
  • Discretion to defer interest (not a default – although this can vary from jurisdiction)
  • Perpetual/ultra long dated (usually not less than 50 years, but may be as long as 1,000 years)

What are Hybrid Securities?

Hybrids are a form of capital in between debt and equity – hence the name. The individual characteristics of the security will define whether it has more debt like or more equity like characteristics.

For example, preferred shares are hybrid instruments but are usually considered more equity like. Convertible bonds have an “equity” component to them, especially if the stock price is trading ahead of the strike price or conversion price on the convertibles – but are otherwise debt. Mandatory convertible preferred shares and bonds are far more to the equity camp.

Keep in mind, all of these instruments, while subordinated to “normal” debt (except convertible bonds, which unless expressly subordinated are just debt with an equity option), are still ahead of equity in the priority waterfall. So if preferred share dividends are cumulative, common equity has to see the preferred equity get paid out all that is owed before they get to see anything.

Here are some things to remember for equity content for an instrument:

Permanent capital: a 5 year bond is not permanent capital, it needs to be taken care of in 5 years. A 50, 60, 80, or 100 year bond is much more permanent. Perpetual bonds are obviously very permanent. Mandatory redemption at the option of the issuer is fine – however mandatory redemption of the holder lowers the duration of the bond. Redemption options can be in the way of a call where the hybrid can be redeemed at a set price at every 10 year interval – it is possible that there are punitive step ups which make it very likely that they will be called, in which case they do not trade that different from a bond with that call period
Optionality of fixed charges: While bond interest must be paid, corporate hybrid bond coupons can be deferred – that said, an issuer would in any ordinary circumstance be reluctant to skip an interest payment and take the concomitant reputational blowback

What is Hybrid Debt?

Hybrid debt is generally very long-dated with a reset period for the coupon based on an agreed upon benchmark bond yield at the reset date.

Coupons are still tax deductible just like straight debt. This is advantageous from a cost of capital perspective – hybrids are expensive versus straight debt but still cheaper than equity options.

The credit rating agencies will usually rate the hybrid two notches below the senior debt. So if hybrid issuer senior bonds are trading at Baa1, the hybrid will trade at Baa3. However, it is implied that the hybrid probably has better true credit quality than the Baa3/BBB- universe.

Hybrid Debt Issuers

The ideal hybrid debt issuers are investment grade corporates with utility like cash flows with a funding gap.

So the usual situation is that a telecom, utility, infrastructure or real estate firm has a large capital program or needs to fund a M&A transaction. They would like to issue debt as equity would dilute existing common shareholders. However, they cannot go all debt because it would impair their pristine credit ratings as Moody’s or S&P will find that they have breached certain debt/EBITDA or FFO/Debt thresholds.

In theory, hybrids could also be used to refinance existing debt to delever (but does not make that much sense unless issued in conjunction with other refinancing of straight bonds as the hybrid coupon is higher).

Hybrids are a great compromise as credit rating agencies give them half debt treatment and half equity treatment, so it does not take the ratings hit. Also, hybrids count as subordinated debt in credit agreements and senior debtholders are not worried about more debt to compete with at their level (they have priority).

Ideally, when the corporate receives the associated cash flows from the capex spend, they will take out the hybrid with straight debt and have a lower coupon.

An example hybrid issuance is Orsted (offshore wind developer) and their 1000 year bonds (yes, 1,000 years!). They receive 50% equity treatment, pay tax deductible interest, are treated as 100% equity from an accounting standpoint and have a rate reset after 10 years (coupon steps up). Orsted’s first maturity is due 3013 (yes, 3013). Two of the subsequent hybrid issues were green bonds – in line with Orsted being one of the greenest companies in the world (with an excellent total shareholder return to date).

Historical hybrid issuers have included Air France/KLM, EDF, Engie, RWE, SES, Evonik, Repsol, AusNet, TransCanada, Emera, Enbridge.

Major investment banks that deal with hybrids include JP Morgan, Bank of America Securities, Citi, Credit Suisse, and the French banks (BNP Paribas, Credit Agricole) – reflecting the product’s inception in Europe.

Hybrid Debt Investors

Hybrid debt investors are the standard institutional investors looking to add high quality credit at a higher interest rate.

Obviously there are associated risks with the higher coupon instrument – especially if the investor is betting on the hybrid being called at the first call date (after 10 years) and it is not.

Compared to the straight debt of the same issuer, the hybrid has much higher theoretical duration (making it far more rate sensitive) and in times of market volatility and a widening credit spread, hybrids can trade well below par.

Also, due to the call/redemption option in the corporate hybrid, there is a ceiling on returns after 10 years hence why they tend to be quoted in yield to worst versus yield to maturity.

Likewise, while the long-term issuer rating for the underlying corporate tends to be high, should credit quality deteriorate precipitously, the hybrid is subordinated to the bank debt and senior bonds. Even if there is no risk of principal loss, interest coupons can be delayed.

Debt Capital MarketsLeveraged Finance Debt Capital Markets in Asia · Accessing Leveraged Capital Markets – Part II · Accessing Leveraged Capital Markets – Part I · Introduction to Green Bonds · Introduction to High Yield Bonds · Acquisition Finance: Bullet Debt · Working in Treasury · Debt Capital Markets Analyst and Associate Work · Interview with: Credit Rating Agency Analyst · Introduction to Convertible Securities · Investment Banking Credit Ratings Advisory · Investment Banking Road Shows: Marketing and Distribution · Differences Between Leveraged Finance and DCM · Early Bond Redemption Analysis · Hedging Interest Rate Risk · Hybrid Securities / Hybrid Debt / Subordinated Debt · Debt Refinancing Options for Issuers ·
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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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