Hybrid Securities

CORPORATE FINANCIAL ENGINEERING

Hybrid Securities
 What is a hybrid financial
instrument
• Hybrid security’ is a generic term used to describe a security that combines
elements of debt securities and equity securities
• Debt security refers to a debt instrument, such as a government bond,
corporate bond, certificate of deposit (CD), municipal bond or preferred stock,
that can be bought or sold between two parties and has basic terms defined,
such as notional amount (amount borrowed), interest rate, and maturity and
renewal date.
• Equity security- usually provide steady income as dividends but may fluctuate
significantly in their market value with the ups and downs in the economic
cycle and the fortunes of the issuing financer
• Hybrids are also debt or equity instruments with embedded options.
Risk and return- the trade off
 Debt and Equity Components
• Hybrid securities typically promise to pay a rate of return (fixed or floating)
until a certain date, in the same way debt securities do. -the debt feature
• However, they also have equity-like features that can mean they provide a
higher rate of return than regular debt securities. In some cases, this is
because they give the holder an option to convert the hybrid securities into
equity securities (typically ordinary shares), which will give the holder an
‘equity-kicker’ if the underlying equity securities perform well.
• In other cases, it may be that the hybrid securities have equity-like risks
attached and the issuer has to pay a higher rate of return to compensate
investors for those risks.
• Hybrid securities are generally complex in nature with
potentially higher risks than other forms of investment
 Types of hybrid securities

• There are three broad types of hybrid securities –

a) Convertibles
b) Preference shares and
c) Capital notes.
Convertible
A hybrid security that gives the holder or the issuer the option to
convert the security into another type of security (often ordinary
shares) at a specified date or dates in the future
Converting
• A hybrid security that automatically converts into another type
of security (often ordinary shares) at a specified date in the
future
 Types of hybrids
Callable hybrid
A hybrid security with a call provision
Putable
• A hybrid security with a put provision
Resettable
• A hybrid security that allows the issuer to re-set the terms (eg by setting a
new interest or dividend rate) after a specified period. Often the holder of
the security will have certain options available to them on the re-set date,
such as to accept the new terms, redeem, or in the case of convertible
securities, to convert into the underlying security
Capital note
A hybrid security that is essentially a debt security but with equity-like features.
Examples include perpetual bonds, subordinated bonds and knock-out bonds
Subordinated bond
• A bond whose rights with respect to payment of interest and repayment of principal
rank behind (are subordinated to) another class or classes of debt. The subordination
may be in favour of the holders of senior debt or to ordinary creditors generally
Knock-out bond
• A bond that give the issuer or a third party a right to extinguish the bond under
certain conditions.
 Types of hybrids Continued
Fixed rate
• A hybrid security that pays a fixed rate of interest over the life of
the security.
Floating rate
• A hybrid security that pays a floating rate of interest by
reference to a variable benchmark interest rate, such as the 90
day LIBOR
 Types of hybrids Continued
Secured hybrid security
• A hybrid security backed by a charge over an asset
Unsecured hybrid security
• A hybrid security that is not backed by a charge over an asset
Step-up security
• A hybrid security where the coupon is ‘stepped up’, that is
increased by a nominated margin, upon a specific trigger
happening. Often the trigger will be the issuer not exercising an
option to repay the security at a particular date.
 Risks associated with hybrid
securities
• Every investment has some risks. The higher the
perceived risk the higher the return
• Key risks to consider when investing in hybrid securities
are:
 Interest rate risk,
 Credit risk
Liquidity risk
 Interest rate risk

• If the coupon rate on a hybrid security is floating, the yield on

the security can usually be expected to stay in line with short-
term interest rates, so movements in interest rates should have
very little impact on its price.
• However, if the coupon rate is fixed, the yield on the security
canInterest
only keep
Rate pace with changing
Hybrid yield interest
Fixedrates if the price of
rate hybrid
theRise
security changes Rise Fall

Fall Fall Rise

 Interest rate risk cont’d

• NB: There is an inverse relationship between the

market price of a fixed-rate hybrid security and expected
yields – the market price will go up if expected yields fall
and will go down if expected yields rise.
• The same thing happens to share prices – share prices go
up if expected dividend yields fall and go down if expected
dividend yields rise.
 Credit risk
• Credit risk is related to the financial strength of the issuer. A hybrid issuer
falling into difficulties could result in the issuer defaulting on payments ie not
being able to pay promised distributions on the face value on maturity.
• Generally, the higher the credit quality of the issuer, the lower the risk
associated with the security and therefore the lower the yield required by
investors.
• Credit risk also includes credit spread risk. This arises when investors demand
a higher spread for securities with higher credit risks compared to lower risk
debt securities, such as government bonds. This is often associated with a
downturn in economic conditions, leading to an expectation of higher levels of
default on higher risk securities
 Liquidity or marketability
risk
• Liquidity risk is the risk of not being able to sell your
investment quickly and easily, or for a fair price, in the
market if you need to. For some hybrid securities,
particularly those with small amounts on issue, liquidity
may be poor
 Complexity risk
• As stated throughout this booklet, hybrid securities may contain
features that are complex and impact significantly on the future
value of the security. While these risks are required by law to be
disclosed in a prospectus or fully understanding them, especially
for investors not familiar with complex financial instruments, is
critical.
• It is very important, therefore, that you read the prospectus for a
hybrid security carefully and if you have any doubt about the terms
of the security, and/or whether it is the right investment for you, to
consult with a financial adviser before deciding to invest
Share price risk (for convertible and converting
securities)

• A convertible security effectively has an embedded option.

The value of that option will rise and fall as the price of
the underlying security (usually an ordinary share in the
issuer) rises and falls.
• This will be reflected in the market price of the hybrid
security. Hence, there is a risk that the market price of a
convertible security will fall if the market price of the
underlying security falls.
Share price risk (for convertible and converting
securities) cont’d

• For converting hybrid securities, the relationship between

the market price of the hybrid security and the market
price of the underlying security is even more direct. Again
there is a risk that the market price of a converting
security will fall if the market price of the underlying
security falls
 What are the special characteristics of
non-rated issuers of corporate hybrids?
• Issuers who already have a number of hybrids in circulation
• Hybrids rated by S&P (as regards the removal of the ‘equity content’
after the first call date)
• First call date not too far away (7 years max for euro-denominated bonds)
• Issuers who take account of their reputation
• Issuers with a stable – or improving – financial profile
• Issuers regarded as major players in the Investment Grade market who
are also making profits (and are thus more likely to pay dividends on
their equity)
 Research

• Discuss the risks and benefits that are

associated with investing in hybrids.
• What are the characteristics of a
corporate hybrid market?
 Capital notes Example
ABC Bank Capital Notes In December 2013, ABC Bank issued hybrid securities called
ABC Capital Notes. The notes are perpetual and pay a discretionary floating rate
distribution that is in the form of a dividend and thus are expected to be fully franked.
The floating rate distribution is paid quarterly and is a margin of 3.20% over the
benchmark interest rate, being the 90 day bank bill rate. The bank has certain
redemption rights including that of redeeming the securities in cash for their face value
on a fixed date in the future. It also has the right to withhold interest payments and/or to
convert the notes into ordinary shares in ABC in certain specified circumstances. In any
winding up of ABC, the notes rank ahead of ordinary shares but behind bond holders
and depositors. Suppose you purchase 500 ABC Capital Notes at the issue date for $100
each. The distribution being variable will be determined by the prevailing 90 day BBSW
rate each distribution date.
Solution:
The distribution is paid quarterly so the amount you are due to receive four times a year
will be: (number of bonds x face value) x (distribution rate / distribution frequency) =
(500 x $100) x (distribution rate / 4) If the 90 day bank bill rate applicable for a
 Preference share Example:
ABC Bank Converting Preference Shares In March 2014, ABC Bank issued hybrid
securities called converting preference shares, maturing in March 2020. The shares
have a face value (issue price) of $100 and pay a 5% per annum fully franked dividend
in semi-annual instalments. The terms provided that the face value of each converting
preference share will automatically convert into ordinary ABC shares on the
conversion date, at a 1% discount to the volume weighted average share price (VWAP)
of those shares over the last 20 days of trading up to the conversion date. Suppose you
purchase 50 ABC Bank converting preference shares at the issue date for $5,000. If
held to maturity, you would receive a fully franked dividend of $125 on each dividend
payment date and if the 20 day VWAP at the conversion date was $25.00, then you
would receive at the conversion date in 2020:
Number of shares = [number of hybrid securities x face value] / [(1 – discount rate) x
20 day VWAP] = 50 x 100 / 0.99 x 25.00 = 202 ABC ordinary shares
 Convertible debt security
XYZ Company convertible note In Example
June 2013, XYZ Company issued convertible notes
with a face value of $100, maturing in June 2018. The securities pay a quarterly coupon
set at 5%. The coupon is in the form of interest and thus no franking credits are
available. The share price at the time of issuance was $2.20. Each note gives the holder
the right to convert on maturity 1 note into 40 ordinary shares giving a conversion price
of $2.50 (that is $100/40). Assume that the share price at maturity of the convertible
note is $4.10. The holder of the convertible notes will have the choice to either convert
each note into 40 shares worth $164 or receive the note face value ($100). Given the
conversion value is higher, the more profitable strategy for holders will be to convert
into shares. Investors who bought the notes on the original issue date and held to
maturity would therefore have earned 5% p.a. and received a capital gain on the notes
of $64 – a total return of $89 or 17.8% p.a. (not including any return from reinvestment
of income received). Assume instead that the share price at maturity of the convertible
note is $2.40. The holder of the convertible notes will have the choice to either convert
each note into 40 shares worth $96 or receive the note face value ($100). Given the
conversion value is lower, the more profitable strategy for holders will be to be paid the
note’s face value. Investors who bought the notes on the original issue date and held to
maturity would therefore have earned 5% p.a. and made no capital gain or loss on the