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What is a Hybrid?

by FIIG Research | Apr 07, 2010

Hybrids are a broad classification for a group of securities, used by a variety of Australian companies to raise money that combine both debt and equity characteristics. Hybrid securities pay a predetermined (fixed or floating) rate of return or dividend until a certain date. At that date the holder may have a number of options including converting the securities into the underlying ordinary shares of the issuer. Therefore unlike a share the holder has a „known‟ cash flow and, unlike a fixed interest security, there is an option held by the issuer to convert to the underlying equity.

This may allow the issuer to classify the issue as equity but also claim tax benefits of issuing debt.

More common examples include convertible and converting preference shares. It is important to note that every hybrid security is structured differently which allows more flexibility as some securities behave more like fixed income securities whilst others behave more like the underlying shares into which they convert.

To be regarded as equity, hybrids must be perpetual in nature that is have no maturity date. So while many such securities have clauses whereby they can be redeemed at the issuer‟s, not the investor‟s option, they technically have no set maturity date. Perpetual hybrids have specific characteristics that set them apart from being valued purely as an equity security including:

  • hybrids typically rank higher in liquidation and priority of payment of dividends than ordinary equity (shares)
  • the coupons (if paid) are pre-determined as either a fixed rated or a margin over BBSW unlike ordinary share dividends where payments can vary significantly

These features are typical of debt securities and mean that while perpetual hybrids are equity like in many ways, they are also lower risk than traditional equity.

Franked or unfranked?

Franked simply means there is a tax credit attached to the dividend, which effectively represents the tax the company has already paid. A fully franked dividend means that investors will receive a distribution which is discounted 30% (company tax rate) to account
for the franking credits they will receive. Unfranked dividends are just dividends that have had no tax paid on them, so shareholders receive a gross distribution which has no franking credit.

Fixed Rate Bonds

A fixed rate bond is a security that pays a fixed pre-determined distribution or coupon. The coupon of a fixed rate bond will be set at the time of issue and will therefore not change during the life of the bond. The Commonwealth Government, state governments, public and private corporations all issue fixed rate bonds in Australia.

Floating Rate Notes

A floating rate note (FRN) is a security that pays a coupon linked to a variable benchmark. In Australia most FRN‟s pay a coupon set at a margin above the bank bill swap rate (BBSW) which is the market benchmark rate for the underlying coupon. The actual coupon for an interest period will be determined at the start of that period by applying the margin to the underlying benchmark on the first day of the coupon period, for example, the three month BBSW. The underlying benchmark rate will rise and fall over time based on prevailing interest rates. The margin over and above the relevant benchmark is usually fixed and will be set at the time of issue.

Floating rate notes can also be issued with additional features such as caps (a maximum value the coupon can take), floors (minimum values the coupon can take) or a step up rate.