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Why corporate hybrids are not all they’re dressed up to be (published 27 March 2006)

Every market participant has had something to gain from corporate hybrid securities. Bond fund managers have delighted in high yields; issuers have enjoyed cheap equity. Ratings agencies have been paid for their trouble, investment banks have pocketed juicy fees and traders have revelled in the volatility. But what seems a perfect fit might well fall apart at the seams in an unfolding credit downturn. This will either expose the defects in the market and destroy it or validate hybrids as an asset class.

How did we get here? | And where are we going?

THE LUNCHTIME CONVERSATION has ranged widely over the advantages for corporate issuers of the new breed of hybrid securities, which investment banks have been championing since the summer of 2005 as the next great thing in capital raising.

Ratings agencies regard these subordinated, perpetual or very long dated bond deals as comprising between 50% and 75% permanent equity capital on the balance sheet. Accountants agree. Maturities can extend and coupon payments be deferred, so providing a loss-absorbing cushion to senior creditors. Yet tax authorities treat the high coupon payments as debt-like interest costs to be paid from pre-tax earnings. And hybrids don’t dilute existing shareholders.

It’s a dream combination.

Over his aperitif, the banker has enthused about hybrids’ potential for financing goodwill on acquisitions, helping bidders stretch their offer prices and funding corporate pension liabilities – all while shoring up credit ratings. Over the main course, he has talked earnestly about lowering companies’ weighted average cost of capital and boosting shareholder returns. It’s only a wonder that more companies haven’t already sold them.

For investors, though, the high yields on these subordinate instruments have to compensate for a lot of risk and uncertainty.

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