VideoHybrid securities, such as convertible bonds and preferred stock, have been in the financial manager's toolkit for decades. They blend elements of equity and debt and can be treated as either one, thereby limiting the amount by which earnings are diluted or leverage added to a balance sheet. Now, a new generation of hybrids has won the blessing of ratings agencies in ways that the earlier ones did not. Bankers claim that companies can use the new hybrids to fine-tune their balance sheets as they see fit.
One company that recently did so is Burlington Northern Santa Fe, which issued a $500 million trust-preferred security last December. The hybrid enabled the railroad company to raise capital and buy back stock without changing its ratio of debt to equity. While Moody's Investors Service considered the hybrid to be 75 percent equity and 25 percent debt, Burlington repurchased enough equity to equalize the effect on its balance sheet.
"We lowered our cost of capital," comments Linda Hurt, Burlington Northern's treasurer, "but we kept our current capital structure." While Hurt declines to quantify the cost savings from the hybrid, which has a 50-year term, she says they are "significant."
Until last year, issuing such a security risked a company's standing with one of the two ratings agencies that dominate this corner of finance, since Moody's considered hybrids to be debt. Then Moody's changed its mind, following a 2005 decision by the Federal Reserve Board to allow internationally active bank-holding companies to hold up to 15 percent of their Tier 1 capital in the form of trust-preferred securities. Moody's announced that it would go along with a previous decision by Standard & Poor's (S&P) to view hybrids partly as equity. The ratings agencies now assign to a hybrid issue a degree of equity content based on several criteria.
A key criterion is whether a hybrid allows issuers to skip payments entirely rather than merely defer them. That's how the new hybrids are typically structured, which is what helped convince Moody's to treat them as equity. In theory, Moody's could consider a hybrid to be fully equivalent to equity, while S&P won't go higher than 90 percent equivalence.
Banks, which were already issuing their own hybrids for their Tier 1 capital, took Moody's decision as a go-ahead to underwrite new corporate issues of trust-preferred securities. "The decision by Moody's kick-started frantic activities among the banks," notes Thibaut Adam, head of hybrid capital structuring for French bank BNP Paribas.
Open Questions
But several key questions about hybrids, particularly those issued by companies, remain unanswered.
One concerns tax deductibility. For hybrids to be feasible, the Internal Revenue Service must see them in the opposite way that ratings agencies do — as debt, not equity. Otherwise, issuers can't deduct as interest the periodic payments they make to investors. Officially, the IRS has been silent on this issue, but banks say private discussions with the agency have convinced them that it will go along — on condition that the securities qualify as debt, including the requirement that they aren't "perpetual," as equity nominally is.
Even if the banks are right about their private discussions, there's always a risk that the agency will change its mind. For that reason, all U.S. deals include a tax call provision, under which the security would be redeemed if the tax deductibility of investor payouts is lost, notes Pamela Fitton, a managing director of BNP Paribas. European issues can forgo the provision, because international accounting rules allow interest payments on equity and other perpetual securities to be deducted.
Accounting poses another potential problem for U.S. issuers, as U.S. GAAP treats hybrids as debt instead of equity. As a result, while an investment bank might convince a company to issue a hybrid, a commercial bank might penalize the issuer, because the hybrid raised the issuer's debt levels in violation of loan covenants. It's even conceivable that a multiline bank could find its investment bankers in conflict with its loan officers over the matter.
Much depends on how rigidly the covenants follow the accounting regime. "If a covenant is written without a lot of flexibility in that regard, you're stuck," observes Charles Mulford, an accounting professor at the Georgia Institute of Technology. In that case, an issuer would have to sit down with its lender and renegotiate its covenants. Burlington Northern's Hurt insists that her company has no problem with its loan covenants as a result of its hybrid, even though the covenants closely follow GAAP.
Still another hitch with hybrids is that they may increase the possibility of a hostile takeover, as happened with convertible bonds in the late 1990s (see "Pick Your Poison" at the end of this article).
Investor Skepticism
A more fundamental question is whether the new hybrids will find buyers. While much of the cost advantage of hybrids depends on favorable tax treatment, the rest depends on pricing. And if investors grow wary of the risks involved, some if not all of the promised cost advantage over straight debt and equity could disappear.
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