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Returns: Predictable dividend, often franked therefore possible tax advantage to the holder
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.
Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share.
Therefore, unlike a share of stock (equity) the holder has a ‘known’ cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares.
A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.
Important terms
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Capital price:
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Price moves in line with share price (fixed conversion terms e.g. 1 hybrid convert to 1 share)
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Bond like, price does not move in line with share price (variable conversion terms, face value (usually $100) convert to $100 worth of shares).
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Discount: A discount is usually offered to the share price at the time of conversion.
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Reset/resettable: At the reset date the terms of the security (dividend rate, next reset date) may change. The holder can elect to accept the new reset terms or convert into shares.
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Cumulative/non-cumulative This refers to the event of missed dividend payments.
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Cumulative: missed dividend payments are added to the next dividend payment.
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Non-cumulative: missed dividend payments are forgone.
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Redeemable/non-redeemable
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Redeemable: At certain times the holder may have the option to sell the securities back to the company at the face value/issue price.
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Non-redeemable / irredeemable: The company is not offering to buy the securities back.
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they have a set dividend until conversion
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the conversion might occur at a number of dates
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they are usually issued at a similar price to the underlying share
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they convert at a set ratio. e.g. 1 hybrid converts into 1 underlying share
Traditional hybrids
Traditional hybrids were usually structured in a way that leads the securities to react to the underlying share price. Although each has individual characteristics, typically:
Note: This fixed conversion ratio means the price of these hybrids react to the movement in the underlying share price. (The extent of the co-relation is sometimes referred to as a delta, and these typically have a delta of between 0.5 and 1) In addition, some of these securities include minimum and maximum conversion terms, effectively giving the holder a put and call option if the share price reaches a certain prices.
Usage
Hybrid securities have skyrocketed in popularity since Moody’s released a new set of guidelines for treating debt-equity hybrids in February 2005. The new guidelines establish a "debt-equity continuum" and allow institutions to classify part of the hybrid security as equity and part as debt (in a shift from the previous policy, that counted the entire amount as debt). This change allowed companies to issue hybrid securities at a time of record low interest rates (and thus gain access to cheap capital) and then use the proceeds to repurchase equity shares (which have a very high cost of capital). Since only a fraction of the recapitalization would be listed as debt on the balance sheet, hybrids allowed companies to repurchase more shares than previously without negatively affecting their credit rating.
Basket D security
The most popular hybrid among financial institutions (banks and insurance companies) is the Basket D security. Basket D is a reference to a point on Moody’s debt-equity continuum scale that treats the hybrid as 75% equity and 25% debt. In order to qualify, the security must give the issuer the right (or even the obligation) to roll-over the security at expiry to an indefinite or long maturity bond and to suspend dividends (effectively coupon payments, but to reflect the equity nature of the security, the term "dividend" is used). Most Basket D issuances have been structured in a way that also preserves the tax deductible nature of their interest payments, avoiding double taxation/customs.