What are hybrid bonds? – Part Two

The advantages for issuers and investors

Part one  |  Part two

Hybrid bonds encountered numerous problems of a legal nature prior to their rightful inclusion among the instruments that a company may issue for self-financing purposes.  In effect, the Italian lawmaker had difficulty in classifying as debt securities any which, as is often the case with hybrids, have no maturity.  First of all, an attempt was made to solve the problem by way of an “escamotage”: the duration of these issues was set to coincide with the life of the company issuing them and therefore – in theory – limited.  Only from 1998 did hybrid bonds establish themselves in the banking sector, due to a specific sector legislation, and in any case only with complex indirect issue structures.  The securities were, in fact, normally placed by holding companies based in Luxembourg and not by the banks themselves.  With the recent reform of the Italian civil code (articles 2410 et seq) the possibility arose also for insurance companies and industrial firms to place hybrid debt directly on the market.  The Lottomatica bond was the first (and hitherto the only) Italian corporate hybrid bond.

These atypical investment forms offer a series of advantages both for issuers and for investors.  The latter should only be institutional investors, namely professionals who can fully understand the specificity of debentures which are completely unique since they involve participation in the company’s risk beyond simple exposure to credit risk.  The greatest benefit derives from the higher remuneration of the investment carried out compared to senior securities: in a bond portfolio, these financial instruments can be included to significantly increase the yield (but at the same time also the risk).

The advantages for issuers are many and varied and they represent a very interesting means of fund-raising compared to the issuance of shares or senior debt.

By using senior debt to raise capital companies would deteriorate their creditworthiness: greater debt means higher risk of insolvency for creditors.  Hybrids, as issues with lower seniority, have a risk and therefore a rating which is different, and does not deteriorate that of senior securities.  In fact, the hybrid tranche might not be repaid or might default without the interests of the senior bondholders being affected.  This characteristic is very useful above all to obtain the financial resources required in the case of major acquisitions, tying interest deferral risks to successful integration with the target company: Lottomatica issued hybrid bonds for 750 million Euro for its acquisition of the American company GTech.

The advantages guaranteed by hybrids with respect to capital increases are event greater.

First of all there is no dilution of the quotas owned by shareholders; the need for the majority shareholders or the consortiums to acquire new shares in order to maintain control is avoided.  Moreover, the shareholders do not incur any reduction in profit which, with an increase in the number of outstanding securities, would be divided between more shareholders. 

Moreover, for the company, the financing cost would in theory be lower: the shareholders – who are the main risk bearers – are looking for higher dividends with respect to the interest payments on a bond, even if junior.

Lastly, the most important stock market multiples used to evaluate the company, such as ROE [1] and price/earnings> [2] in particular, do not deteriorate as in the case of capital increases.

[1] Acronym of Return on Equity, this is an important measure of the profitability of shareholders’ equity.  The indicator is calculated as a ratio between net profit and the average book value of shareholders’ equity during the period.  

[2]This is the most widely-used stock market multiple, calculated as the share price divided by net profit.  In practice, it indicates how many times investors are presently prepared to pay for the future years’ profits of a certain company on the assumption that they will be the same as those for the current year.