Capital Markets

Time to Test-Drive Hybrids?

The market for bonds with both debt and equity features is heating up, again.
Stephen TaubNovember 30, 2005

Hybrids are gaining in popularity.

No, not hybrid cars, hybrid bonds. Three deals were launched this week alone, according to The Financial Times, in what is shaping up into a growing trend.

Hybrid bonds combine the regular interest payments of bonds with features of equity, including ultralong or perpetual maturities and the opportunity to defer coupon payments. These products have been around for awhile, but the FT points out that Moody’s Investors Service gave the bonds a boost when it clarified its position by issuing guidelines on how it would treat the products.

“Hybrids used to be expensive debt, but now they’re inexpensive equity for rating agency purposes without any share dilution,” Michael Regan of Citigroup’s global new products group told the paper. To be sure, the trick for investment banks that sell the product is to develop structures that combine the tax deductibility of bonds, but remain equity-like from a credit-ratings point of view.

U.S. issues are not tax deductible if they have a perpetual maturity, the FT notes. However, rating agencies require long maturities in order to give the debt a high-credit-rating equity treatment. A compromise has been found in the 40- to 60-year maturity range, which is long enough for Moody’s to assign a D-basket equity credit, reports the newspaper. This means 75 percent of the funds raised are treated as equity.

“Some are calling them ‘Holy Grail’ products, where they are non-dilutive to common stock but the rules still allow you to take tax deductions,” Kevin Ryan, who oversees the hybrid capital initiative in the United States at Morgan Stanley, told the FT. “As people have looked at this and worked through the issues, we’re seeing a lot more interest in the structures.”

In August, Lehman Brothers issued a $300 million security on its own behalf, dubbed an Ecaps, or Enhanced Capital Advantaged Preferred Security. The three deals launched on Monday were a $400 million issue for Reinsurance Group of America and $500 million or larger deals for both Zurich Financial and ING Group, reported the FT.

In addition, Citigroup and Goldman Sachs recently led the first deal ever for a nonfinancial company — a $450 million issue for toolmaker Stanley Works, a structure dubbed an Etrups, or Enhanced Trust Preferred Security.