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To get the best aspects of debt and equity, corporates in the US and Europe
are piling into so-called hybrid financing, creating an instrument that has more
flexibility than senior debt and reduces the cost of capital. The boom in hybrid
issuance has been driven by changes in the way the credit rating agencies treat
these instruments.

Their flexibility is recognised by Standard & Poor’s and Moody’s and
given a certain amount of equity credit. The rules, particularly pertaining to
Moody’s, changed about a year ago in such a way that they became clearer and
more favourable towards hybrid instruments.

With the fresh approach adopted by Moody’s, corporates are now much more
comfortable with the level of credit they obtain with a hybrid instrument. S
&P and Fitch have clarified and updated their views to reflect the fact that
the market has grown and changed with regard to structures that they felt needed
to be addressed.

“An issuer can get more equity credit for an instrument now, according to
Moody’s, than in previous years,” says Jennifer Piekut, executive director and
global head of Morgan Stanley’s Capital Products Group. “From the equity
perspective, there are features built into a hybrid that replicate those you
would find in ordinary shares.” There are three equity-like aspects to hybrids:

Long-dated Hybrid instruments are typically structured to be
long-dated or even perpetual. An issuer has no obligation to repay, or that
obligation is far out in the future.

Subordinated The second factor that makes hybrid capital
more akin to equity is the subordination of the instrument. “It is typically
subordinated below all debt and senior to common equity,” says Piekut. “But by
virtue of this subordination relative to senior debt, hybrid instruments create
a cushion.”

Interest deferral The third aspect is the option to defer
interest payments. “There are many ways to achieve this, but all hybrids will
have some form of deferral risk built in, so an issuer can, in certain
circumstances, choose not to pay the hybrid capital dividends,” Piekut explains.
“By having some coupon deferral it’s similar to an ordinary share, in that if
the company is in trouble it has full flexibility to suspend ordinary share

Hybrid instruments also have features that make them more like debt. Piekut
points out that these instruments typically pay a fixed coupon and have a fixed
liquidation value. “If the company does well you don’t have equity upside and
only get back what you put in, which is par value,” she says, drawing the
distinction with convertible bonds, the original debt-equity hybrids. “Hybrids
are typically non-voting and structured to be tax deductible in whichever
country you’re dealing with, which makes them more similar to debt.”

This newest generation of hybrid capital has taken off in the US in the past
six months or so and there have been some important changes on the bank
regulatory side that create a new opportunity for US banks.

In Europe, where the bank regulatory environment has been stable for the past
seven or eight years, it has been the changes on the part of the rating agencies
that have driven the market. Whether investor appetite for such higher-yielding
products survives a downturn, in which corporate issuers exercise their right to
defer interest payments, is yet to be seen.