What are hybrid bonds – Part One

How they differ from Senior Bonds

Part one  |  Part two

The year 2006 saw the growth in popularity of hybrid bonds, especially as regards the Italian market.  Since January, in fact, these particular bonds have been included in the iBoxx index [1] (which led to an enormous increase in the liquidity of these securities on the part of mutual fund managers); moreover, in May the first Italian hybrid bond was issued.  The security in question was issued by Lottomatica for a nominal value of 750 million Euro.  This is also the first hybrid in the world with a rating [2]just two notches below the corresponding senior debt [3].

But what exactly is a hybrid bond and how does it differ with respect to senior bonds?

A completely univocal definition is not easy, since this category includes a series of innovative instruments which depending on the issues can have very different characteristics.  The greater flexibility of hybrid bonds places this group of instruments almost half-way between pure debt and venture (equity) capital.

Common characteristics normally concern:

Subordination – the security has a seniority superior only to that of equity instruments and is subordinated to all the company’s other bond issues.  This means that in case of bankruptcy the holders of these instruments will be repaid only after all the other bondholders have already received their dues, but before the shareholders.

Duration – this is usually very high, beyond ten years and may sometimes even coincide with the life of the company; in such case they are referred to as perpetual bonds and are very similar to shares.

Call clause – the issuer has the possibility to redeem the loan early.  Usually if this right is not exercised an increase in the interest payment is provided for (step-up clause)

Interest deferral – the issuer can postpone one or more interest payments upon the occurrence of certain events.  These may concern the non-payment of dividends on the part of the company, or negative operating results, or EBIT below a certain level.  In some cases the suspended payments may be honoured thanks to proceeds deriving from the placement of new shares or new hybrids even similar to those already present on the market.  Some issues even offer the possibility to skip an interest payment entirely if the company’s results are poor.

These characteristics – particularly the reliance of the interest payment on the economic results of the issuer companies and the perpetuity – make hybrids very similar to equity instruments.  There are, however, substantial differences.  First of all hybrids must pay a contractually-set income flow and there can be no provision for distribution of a part of profits: the interest payment can never be increased.  Moreover, and more importantly, the holders of hybrid debt , whilst participating in the company’s risks to a much greater extent with respect to ordinary bondholders, have no control over the company’s policies or any right to vote at Shareholders’ Meetings.  It should also be mentioned that, since such instruments are reserved for the institutional market, the subscribers are major financers of the company and often invest in the firms even more capital than the main shareholders.

In the next article we will be looking more closely at the advantages offered by hybrid debt compared to senior debt and capital increases.

[1]iBoxx indices are a major benchmark for mutual funds investing in bonds.  These include investment grade securities (namely those with at least a triple-B rating) of the Euro or British Pound zones.  They are also used as an underlying for some derivative instruments.

[2] A rating is an evaluation of creditworthiness, in other words the solvency, assigned to the issuers of bond loans.  The three most important rating agencies are Standard & Poor’s, Moody’s and Fitch.  For example, for S&P and Fitch a triple-A (AAA) indicates the highest degree of reliability, whereas a D rating refers to companies that have already gone bankrupt.

[3] Senior debt is the form represented by the most “traditional” bonds; in case of a company’s bankruptcy or financial difficulty, the holders of senior securities will be repaid before all the other holders of debt vis-à-vis the issuer and shareholders.  The seniority refers to the priority with which investors are repaid.