Hybrid Financial Instruments

CHAPTER 1: INTRODUCTION, MEANING & DEFINITION

1. INTRODUCTION

A hybrid financial instrument is an investment that blends characteristics of both equity and debt markets (stocks and bonds). Hybrid financial instrument are also known as hybrid securities. The most common form of a hybrid instrument is the convertible bond. This type of security is an issuance of debt that can be converted to a company's common stock at any given time. So, it is kind of like a call option. Obviously, the major advantage of this type of security is that if the corporations stock price goes down, the option will not be exercised and you will still receive interest payments on your bonds. However, if the stock price goes up,
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you can convert the bonds to stock at a given strike price. If the price of the stock is above the strike price, the convertible is considered in in the money." The major advantage here is security. There is opportunity to profit greatly on increases in stock prices, but at worse case you will still hold the debt security. The only way you can realize "real" losses is if the corporation defaults on its debt. One disadvantage of a convertible is a low yield. Convertibles often yield a lower interest rate than the corporations no convertible bonds due. One important thing to point out when dealing with hybrid securities is they are very difficult to accurately value, and this misrepresentation is often reflected in its market value. This leaves a lot of opportunity for an arbitrage situation, where a security can be purchased then immediately sold for a profit simultaneously. There are other types of hybrid instruments including preferred stock, trust preferred securities, and equity default swaps. However, convertible debt is the most commonly used security to the individual investor. Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares. A hybrid security is structured differently and while the prices of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.

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2. MEANING
The term hybrid instrument is not precisely defined. Generally, it is used to refer to financial instruments that blend characteristics of debt and equity markets. Convertible bonds are an example. They are debt instruments that have an imbedded option allowing the holder to exchange them for shares of the issuing corporation's stock. For this reason, their market prices tend to be influenced by both interest rates as well as the issuer's stock price. Another example would be a structured note linked to some equity index. These take many forms. Typical would be a five year note. It is a debt instrument issued by a corporation or sovereign, but instead of paying interest, it returns the greater of, principal plus the price appreciation on the S&P 500 over the life of the instrument, or Principal. Other examples of hybrids are preferred stock, trust preferred securities (TruPS) or equity default swaps (EDS). Hybrid securities can be spotted by their labels, such as preferred, convertible or redeemable. The name placed on a security, however, is a minor factor in determining whether it should be treated as debt or equity. The most important factor is the financial operation of the security. The essential instrument underlying many hybrid issues is a deeply subordinated security, which usually has the capacity to pass on interest, and ranks lower than straight subordinated debt in a liquidation scenario. There are many
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variations on this common theme, ranging from simple preference share and capital note issues, to complex instruments that involve the combination of two junior subordinated debt securities through a stapling arrangement. There are greater similarities between common equity and garden-variety hybrid capital instruments (such as preference shares) than between common equity and hybrids that are more debt-like in nature (such as trust preferred securities). Accordingly, greater credit is allowed for preference shares in assessments of a financial institution's adjusted total equity.

3. DEFINITION
1. A security that combines two or more different financial instruments. Hybrid securities generally combine both debt and equity characteristics. The most common example is a convertible bond that has features of an ordinary bond, but is heavily influenced by the price movements of the stock into which it is convertible. 2. An investment product that combines the attributes of an equity security with a debt security. Generally, hybrid instruments are designed as debt-type instruments with exposure to the equities market. Examples of hybrid instruments are convertible bonds, preferred stocks, equity default swaps and structured notes linked to an equity index. Also called hybrid securities. 3. A financial security that has two or more characteristics of other financial instruments such as equities, bonds, swaps, forward agreements, futures, or options. The return often is based on the return of two or more underlying

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instruments such as exchange rates, interest rates, or equities. Also called a structured financial transaction.

How it works/example:
For example, a convertible bond is a hybrid security because it is a bond that allows the holder to exchange the bond for other securities (usually the issuer's stock). Mechanically, convertible bonds let the holder use the par value of the bond to purchase other securities from the issuer at a specified price. For example, consider a Company XYZ bond with a $1,000 par value that is convertible into Company XYZ common stock. If the conversion price of the common shares is $25, then the bondholder can convert each of his or her bonds into 40 Company XYZ shares ($1,000 / $25 = 40). In this scenario, we would say that the conversion ratio is 40:1. Many hybrid securities are callable, meaning that under certain circumstances the issuer can redeem them before they mature.

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Why it matters?

Hybrid securities require their investors to conduct extra analyses. For instance, the conversion price is not the only aspect of a convertible bond to analyze. Like other bonds, convertible bonds usually offer a coupon, and their prices are based on prevailing market rates and the credit quality of the issuer. Because conversion would mean losing those interest payments, investors also compare the coupon payment of the bond to the dividend yield of the common shares when they're thinking of converting. Another thing to consider when investing in hybrid securities is their trading behavior. For instance, the more a convertible bond is "in the money," that is, the more the market value of the shares exceeds the conversion price, the more the bond itself trades like a stock. The bond's price tends to rise as the stock price approaches the conversion price (similar to a call option). The more volatile the stock price when in this zone, the more volatile the bond price. Interestingly, this relationship allows
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convertible bond holders to participate in the company's stock price appreciation.

How are they different to equities?

In general, hybrid securities have the following characteristics:

They rank higher than equity but sit below secured and unsecured debt. This ranking reflects the rights of hybrid holders to be paid out before equity in the circumstance of a wind up of the company. It is very rare for public companies to be wound up, but it is not unheard of.

A hybrid security typically has a face value of Rs.100. This is the redemption or conversion value if it is to redeemed or converted into equity.

Hybrid securities pay a regular fixed or floating rate of return or dividend until a certain date. In this regard, holders are paid interest or dividend for holding the security for a predetermined period.

At maturity or on a reset date, the issuer may have the right to decide one of the following options: convert the hybrid securities into the underlying equity of the issuer; redeem the hybrid securities, usually at face value; or roll into another hybrid structure or even a combination of the above.Alternatively, the issuer may arrange a third party to purchase the hybrid from the security holders.

In most circumstance the issuer of the hybrid security cant declare and pay a dividend for its ordinary equity unless the hybrid securitys divid end or interest payment is first declared and paid. Investors should also determine whether hybrid distributions are cumulative or non-cumulative. A cumulative hybrid security is more valuable as unpaid interest or dividends may be an unsecured debt of acompany in a winding up.

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The issuer may suspend payment of dividends under certain conditions. The trigger for suspending payment can vary for each hybrid security but the trigger conditions usually result from the issuers bankers debt covenants.

Most issuers retain the right to redeem perpetual notes early and will do so if attractive alternative funding is available.

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CHAPTER 2: FEATURES, OVERVIEW, BENEFITS

1. FEATURES OF HYBRID SECURITIES Hybrid securities are securities which combine features of both debt and equity. They offer payment of regular distributions at a predetermined rate for a specified period, similar to conventional debt, and are often described as "fixed income securities". However, hybrid securities will also have one or more equity characteristics such as the ability of the issuer to defer distributions, subordination to creditors and convertibility to equity, which mean they carry greater risk of loss of investment than conventional debt products. There is no fixed definition of what constitutes a "hybrid security" and the expression encompasses a diverse array of financial instruments, such as converting or redeemable preference shares, convertible notes and other forms of unsecured notes, and a wide variety of commercial terms. This means that, in terms of risk and return, hybrids can sit anywhere across the debt/equity spectrum. Regardless of the underlying nature of instrument used, hybrid securities can be categorized by reference to certain key structural features, such as:

whether the "dividends" or "distributions" paid on the security are fixed or floating;

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whether the payments of distributions may be deferred and, if so, in what circumstances some hybrids provide for voluntary deferral at the discretion of the issuer, others provide for mandatory deferral where the issuer is in breach of certain financial ratios, such as interest cover or leverage ratios and some have no deferral rights;

Whether deferred distributions are cumulative or non-cumulative. Recently, a number of issuers have deferred payments where payments are noncumulative, with significant value implications for holders;

whether distributions are franked or unfranked; The maturity date of the securities while some hybrids are technically perpetual, most hybrids have an initial "call date', when the issuer can redeem or convert the securities, of between 5-10 years. Often there are potential disincentives for the issuer to leave the securities on foot after this initial call date such as an automatic "step-up" in the interest rate on the securities or a change in the treatment of the securities for ratings purposes; whether the hybrids may, or must, convert into ordinary shares the recent trend is away from conversion rights; whether the security has any "equity optionality" some hybrids enable holders to benefit from share price increases above a specified level but most do not;

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the level of subordination most hybrids are subordinated to all other creditors and rank either ahead of or equally with equity; and What happens on a change of control the rights of holders on a change of control vary greatly from the right to convert to participate in any "takeover premium" to no right to redeem unless the rating of the issuer is adversely affected. Care needs to be taken to ensure the hybrids do not operate as a poison pill on a change of control.

2. OVERVIEW OF HYBRID CAPITAL SECURITIES

Hybrid capital securities, or securities that have some equity characteristics and some debt characteristics, have been popular for over a decade. Hybrid securities lie somewhere along the equity-debt continuum, but where exactly, is the subject of great debate, and depends largely on the terms of the instruments as well as the provisions of applicable national laws. In fact, over its life, a hybrid security may exhibit different proportions of equity like or debt-like traits, sliding along the continuum.

This section outlines:

The format that hybrid securities can take. The objectives associated with hybrid capital. Some common types of hybrid securities.
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The types of companies that have issued hybrid securities. The relevant legal framework to consider in structuring a hybrid capital security. The main bank regulatory requirements and how these differ by jurisdiction. The main tax considerations and how these differ by jurisdiction. The accounting considerations. The ratings considerations. How hybrid securities can be offered and how and to whom they are usually marketed.

Format
Hybrid securities include: Certain classes of preferred stock. Trust preferred securities. Convertible debt securities. Debt securities with principal write-down features. Mandatorily convertible instruments.

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3. THE BENEFITS OF HYBRID SECURITIES

1. Hybrid securities combine characteristics of financial instruments which feature equity and debt commitments. The characteristics of hybrids range from shares that are interest bearing to convertible bonds that are mandatory. These instruments are recorded on the books of the company at the bottom of the capital structure of the company that issues the securities. 2. Hybrid securities are used to protect creditors, depositors and policyholders of a financial institution which is regulated to offer a capital pillow to soak up any unforeseen possible losses coming from the operations of the issuer. Hybrids are subordinate to external creditors claims and on the issuers liquidation the principle securities amount is junior to ordinary debt, however it is senior to equity. 3. One of the attractions of hybrids is that they are cost effective because its possible to structure coupon payments so that they are tax deductible. In combining the equity features required to satisfy regulatory jointly with the essential debt characteristics enabling qualification for tax deductibility. Hybrid securities optimize the capital structure of an issuer.

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4. The benefits to an issuer are that the finance is long term and cost effective when compared to issuing shares to increase capital. Issuing hybrid securities does not dilute capital as a share issuance does. If the mix of the hybrid is optimum with both equity and debt characteristics the coupon payments can be offset against the operating income of an issuer through tax deductions. Hybrid securities also enable more flexibility in managing the balance sheet of the issuer and thereby in most cases improve important financial performance ratios such as return on equity. Issuing hybrid

securities also gives the issuer access to forex-trading markets they might not have had access to before such as a different investor base for fixed income securities and a more diversified array of funding sources. 5. Although the issuer should make sure that the issuance is structured in order that the hybrid has a legal characteristic which deems it as debt there are jurisdictions where the law may stop the interest on the hybrid being tax deductible because hybrids are treated as equity for the purposes of accounting or are considered to be the same as long dated debt securities or it is deemed that the hybrid was issued solely to gain a tax advantage.

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Supporting investors in making informed decisions:Hybrid financial instruments are often carefully structured and can adversely affect returns to other investors. Accounting for hybrid financial instruments is complex and can require significant judgments. The terms therefore, of the instrument and judgments made, need to be carefully disclosed to support investors in making informed decisions.

Issuers should pay careful attention to disclosure of:

How the classification of the instrument as debt or equity was determined, linking this to critical terms of the instrument, explaining those terms and any significant judgments applied. Other critical terms that may impact returns to other investors, including dividend stoppers, whether interest is cumulative and any step-up penalties.

SEBI will continue to monitor financial instruments disclosure for improvements based on the findings contained in this report. SEBI has received enquiries from investors about the classification and disclosure of financial instruments in financial statements. Accounting standards contain complex rules to classify certain financial instruments, or components thereof, as debt or equity. These rules can, and do at times, conflict with directors, investors, and other regulatory framework assessments of those instruments. The terms of these financial instruments can impact the returns of other investors in the entity. As a result, detailed disclosure is often necessary to facilitate informed investment decisions.

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CHAPTER 3: TYPES
1. DIFFERENT TYPES OF HYBRID SECURITIES 1. Income notes and securities:
Have no maturity date or a very long maturity. They usually pay floating rate coupons. The issuer normally has the option to redeem them but it is unlikely this will ever happen. These hybrid securities are usually perpetual and pay a quarterly distribution or interest priced at a margin above the 90-day Bank Bill Swap (BBSW) rate. This sub-group of hybrid securities is most like debt and will trade in the market based on movements in credit spreads in corporate debt markets. Credit spreads are the interest margin above say a 90 day bill rate and vary according to a companys credit rating. An example of this type of hybrid is the National Australia Bank Income Securities (NABHA). As they are perpetual, the holder has no rights to redeem and needs to sell on market to realise their capital. They are at the lower end of the risk spectrum and one of our preferred hybrids.

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2. Reset preference shares:

Typically have a coupon that is set for a defined term, normally five years. At the end of the five-year period, the preference shares are remarketed, where they are either redeemed or a new fixed coupon rate is set. These are predominantly issued at a fixed rate and usually have a life span of five years from the point of issue. They pay a fixed coupon, usually semi-annually. At the end of the five-year period, they are reset at a prevailing rate of the market rate for similar credit rated securities. Alternatively, at this time, the issuer can opt to redeem the preference shares for cash at the face value. In most of these cases, the dividend paid is fully franked. Examples of these are the IAG Limited Reset Convertible Preference Share (IAGPA) and Bank of Queensland Reset Preference Shares (BOQPA).

3. Converting preference shares:

Convert into the ordinary shares of the issuer after a defined period assuming certain conditions occur. Most converting preference shares offer the option for the issuer to redeem them for cash but conversion into shares is usually the default option. The convertible preference shares are hybrid securities that convert into the underlying ordinary shares of the company after a certain fixed time frame, provided the conversion conditions are met by the end of the period. The conversion is usually priced at a discount. Under some conditions, the issuer can opt to redeem the preference share, although it is at the sole discretion of the issuer.
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Some of the examples in this group are the more recent banks hybrids such as CBAPA, ANZPA, WBCPA and WBCPB, issued by Commonwealth Bank, ANZ and Westpac.

4. Step up preference shares:

Is the most common type of corporate hybrid and normally pay a floating rate coupon and have a call date after a set period, normally five years. If these securities arent called at the first call date, then the coupons step up to a higher rate to compensate investors for non-redemption. These hybrid securities normally pay a quarterly or semi-annually dividend priced at a margin above the 90-day or 180-day BBSW rate. At some point in the future normally five years from the point of issue the issuer has the option to redeem these preference shares or step-up the margin to a higher rate of dividend to compensate the holders for the non-redemption. They may also be an option to arrange for a third party to purchase these securities from the existing holders. Examples of these hybrid securities are Woolworths Limited Unsecured Floating Notes Securities (WOWHB), Commonwealth Bank PERLS III (PCAPA) and Westpac Trust Preference Shares (WCTPA). PERLS III is another of our preferred hybrid securities for investors with lower risk tolerance.

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5. Stepped up preference shares:

Are step up preference shares that have already passed the step up date and pay a higher coupon over and above the original coupon. The issuer has the option to redeem the securities on any future coupon payment date. As the name implies, these are preference shares or securities where the margin has already been stepped-up because the issuing company opted to not redeem the preference shares at the reset date. They are now technically perpetual securities, reset at a higher distribution rate. Generally, redemption of these securities is at the sole discretion of the issuer. Examples in this group are Australand Assets Trust Preference Shares and Multiplex Sites Trust Preference Share (MXUPA). These hybrids at the higher end of the risk spectrum; for investors prepared to take on that risk, they are among our top picks.

6. Preference Capital :

Preferred stock (also called preferred shares, preference shares or simply preferred) is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company) and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the articles of association.
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Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferred is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. This capital is always preferred at the time of distribution of the dividends. Again, preference capital is paid first when the company is winding up its activities. The equity capital always comes next. According to financial theory, preference capital is one type of financing. Preference capital carries preference to the shareholders at the time of winding up of company and dividend payment. The preference capital is also referred to as the capital contributed by the preference shareholders. The preference shareholders receive dividends in the fixed rate but they do not enjoy voting rights.

7. Warrant:
Warrant is a kind of hybrid financing and it is very close to security options. Any person who is holding a warrant is guaranteed to be provided with specific number underlying instruments and the prices for that instrument are fixed previously. This means that if the value of the particular instrument is going up the investor can make good amount of profit and if the market is not favorable, the warrant-holder is not bound to use the warrant. Like securities market, here also both the call and put warrants are available. In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have
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expiration dates. The word warrant simply means to "endow with the right", which is only slightly different from the meaning of option. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable and can be sold independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends. Warrants are actively traded in some financial markets such as Deutsche Borse and Hong Kong. In Hong Kong Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable bull/bear contract.

8. Convertible Bonds:

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Convertible bonds are the most common type of hybrid securities. Companies issue convertible bonds to attract investors who want the possibility of higher return but not the risk of owning stock at the outset, explains Investopedia. Holders of convertible bonds are allowed to convert each bond for certain shares of common stock when the stock rises in value. Absent such an upside, investors would continue to receive interest payments, plus the protection of invested principal. Offering convertible bonds also benefits the company. Compared with conventional stock offering, convertible bond issuance is quicker and the new capital does not dilute company earnings, according to information about convertible securities from the SEC website. Moreover, companies pay less interest on convertibles than on regular bonds because issuers are allowing bondholders to potentially benefit from a common stock conversion.

9. Convertible Preferred Shares:

Convertible preferred shares are another type of hybrid security. Similar to convertible bonds, convertible preferred shares also retain a lower risk profile but with the potential for higher return when they are converted to common stock for capital appreciation. For the issuing company, not only do preferred shares not dilute existing common shareholders' value, but they are also considered part of the issuer's core capital for accounting purposes. Core capital is also known as tier 1 capital, especially useful when measuring a bank's capital adequacy. Institutional investors may also choose convertible preferred shares over convertible bonds for tax reasons. IRS permits institutions that pay corporate tax to exclude 70 percent of their received dividends from taxable income, whereas interest earned is fully taxable at the higher ordinary income rate.

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These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company's common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the investors' capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in the share price.

Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.

10. Exchangeable Bond:

An exchangeable bond gives the holder the option to exchange the bond for the stock of a company other than the issuer (usually a subsidiary) at some future date and under prescribed conditions. This is different from a convertible bond, which gives the holder the option to exchange the bond for other securities (usually stock) offered by the issuer. How It Works/Example: For example, let's consider a Company XYZ bond that is exchangeable into shares of Company ABC at an exchange ratio of 50:1. This means that you could exchange every $1,000 of par value you own of XYZ bonds into 50 shares of ABC stock. This effectively means you have the option to purchase Company ABC stock for $20 per share ($1,000/50). If ABC shares were trading for $50 per share, you would probably exchange the bond and then sell the shares, pocketing a profit of $30 per share ($50 received per share - $20 paid per share). But if ABC shares
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were trading for $10 per share, you would have no incentive to convert the bond and would instead simply continue to receive coupon payments.

Exchangeable-bond holders, like convertible-bond holders, usually accept lower coupon rates because they have the chance to profit from the underlying stock's increase. Likewise, issuers often give up equity in return for these lower interest rates. Exchangeable bonds typically mature in three to six years. Why It Matters: Clearly, one opportunity (or one risk) of investing in exchangeable bonds is that the investor is exposed to an underlying stock that may have an entirely different risk and return profile from the issuer. Thus, investors have the option to invest in an entirely different company if they want to. In this sense, exchangeable bonds come with a built-in diversification option. Some investors view exchangeable bonds as stock investments with coupons attached. This is because exchangeable bonds trade like bonds when the share price is far below the exchange price but trade like stocks when the share price is above the exchange price. This correlation with stock prices means exchangeable bonds provide a little inflation protection, which is especially attractive to income investors and especially noteworthy given that corporate bonds largely provide little if any inflation protection. Companies often use exchangeable bonds as a method to sell off their positions in other companies. But another major advantage of exchangeable bonds (for issuers) is that they do not dilute the issuer's shareholders. Recall that investors can turn convertible bonds into shares of the same issuer, which forces the issuer to issue more shares and causes dilution. Because exchangeable bonds turn into shares of another company, no such dilution occurs.

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11. Convertible Debenture:

Convertible debentures are those that can be transformed into the shares of the same company. These debentures are also known as convertible bonds. The ratio of conversion from bond to share is fixed by the company and the bonds are usually converted to common stocks. Convertible debentures are different from convertible bonds because debentures are unsecured; in the event of bankruptcy the debentures would be paid after other fixed income holders. Convertible debentures are a way corporations raise large amounts of capital to fund their operations. They are sold to investors for an amount that represents principal. The corporation pays interest on the principal and then, at the maturity date, pays back the principal. The special feature of a convertible debenture is that the investor, instead of receiving the return of principal, can convert the debenture to stock of the corporation.

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CHAPTER 4: RISKS INVOLVED, & OBJECTIVES

1. RISKS INVOLVED IN HYBRID SECURITIES

Hybrid securities have higher risks than most types of corporate bonds. While the conditions, timeframe, risks and interest rates of each hybrid offer differ, some have particularly complex features and risks: 1. Market price volatility - Like company shares, the market price of listed hybrid securities may fall below the price that the investor originally paid, especially if the company suspends or defers interest payments, or if its performance or prospects decline. Changes in the company's share price and in other interest rates may also be reflected in the price of the listed hybrid security. See the case study below for an example of how this works.

2. Subordinated ranking - Hybrid securities are generally unsecured, meaning that repayment is not secured by a mortgage or security over any asset. If the company issuing the hybrid securities becomes insolvent, hybrid
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investors generally rank behind senior bondholders and other creditors. If a company fails, hybrid investors have to line up behind these creditors and bondholders in the queue for their money.

3. Non-viability clause - Hybrids recently issued by banks and insurance companies have a non-viability clause. This means that if the bank or insurance company experiences financial difficulty they may be required to convert the hybrids to shares. If the shares are worth less than the hybrids, this could mean a loss for investors.

4. Conversion to shares - Some hybrids issued by banks and insurance companies are scheduled to convert into shares after a fixed period. This is subject to conditions, and the bank or insurance company may have the option to redeem or 'buy back' the hybrid before this occurs.

5. Deferral of interest payments - Some offers allow the company to suspend interest payments for a number of years. While the interest owing may be cumulative (meaning it should be compounded and repaid to investors later), this could leave investors temporarily out of pocket. The security's market price may fall due to the decision to hold back interest payments.

6. Early termination - Some hybrid offers allow the company to terminate or 'buy back' the investment early but do not give that same right to investors.

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7. Extremely long timeframes - Some hybrids have investment terms lasting several decades. For example, with a 60 year term, a 40 year-old investing today would need to live to 100 to see their investment mature. You may be able to sell the security on a secondary market such as the ASX, but only if there is a demand for that security. And the risk of a company defaulting on its obligations, or eventually running into financial difficulties, increases over the long-term.

2. OBJECTIVES

Issuers like hybrid securities because they are considered an attractive, costefficient means of raising non-dilutive capital. Hybrid securities are issued by financial institutions, including banks and insurance companies, as well as by corporate issuers, which are generally utilities. Hybrid securities often receive favorable treatment by ratings agencies and regulators when they analyze an issuer's capital structure. Many hybrids also provide a lower after-tax cost of capital for issuers compared to common stock.
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Historically, an issuer and its advisers sought to structure a hybrid security that:

Qualified for favorable equity treatment from rating agencies.

Allowed the issuer to make tax-deductible payments.

Qualified as Tier 1 capital for bank holding companies.

The benefits of a hybrid security depend on its "equity-like" or "debt-like" characteristics. From a rating agency and bank regulatory-perspective, more equity-like hybrids generally receive more favorable treatment. From a tax perspective, more debt-like hybrids offer more favorable tax treatment for issuers.

When structuring a hybrid security, it is helpful to identify the core elements of common equity and the core elements of debt. There are a number of characteristics associated with "pure equity", including no maturity, no ongoing payments that could trigger a default if unpaid, and loss absorption for all creditors. For example, common stock has no compulsory or fixed repayment obligation or term.

In contrast, debt usually has fixed payments and a stated maturity. An issuer can elect not to pay dividends on its common stock, but non-payment of principal or interest on a debt security generally constitute an event of default. Common stock provides "loss absorption" for an issuer, meaning that common

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stockholders are the last class of security holders to receive distributions in liquidation. By contrast, debt holders have a right to receive payments before equity holders.

Preferred stock may entitle the holder to a dividend, subject to declaration by the issuer, and may entitle the holder to some voting rights. As with common stock, non-payment of a preferred stock dividend will not trigger an event of default. However, non-payment may breach a covenant or other contractual undertaking by the issuer. Dividend payments may be cumulative, or noncumulative.

Preferred stock may be convertible, at the option of the issuer or the holder, or mandatorily on the occurrence of certain events. While senior to common stock in liquidation, preferred stock provides some measure of loss absorption, by ranking behind unsecured debt in terms of priority of payment, in a bankruptcy or other degraded financial situation.

Most hybrids contain a deferral feature (optional or mandatory) that permits the issuer to defer the payment of interest or dividends. Hybrids also generally are deeply subordinated within the issuer's capital structure. Like an equity security, non-payment of distributions does not result in an event of default. In fact, a hybrid security holder has limited rights against the issuer for deferred interest payments.

In certain structures, deferred interest may be permanently cancelled if certain conditions are satisfied and, as a result, the holder of the hybrid security may forfeit its claim for deferred interest amounts. In other structures, the treatment

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of deferred payments is bifurcated. After some deferral period, the issuer must pay deferred interest through the issuance of capital (an alternate payment mechanism) up to a cap.

An alternate payment mechanism requires that deferred distributions on the hybrid can only be paid out of the proceeds from the issuance of more junior or parity securities or through payment-in-kind. In bankruptcy, however, the security holder's claim is limited to a maximum deferred interest amount.

Why invest in Hybrid Instruments?

A) Hybrids can enhance the income returns of a diversified equity portfolio and they also offer downside protection because the strong yields should place a floor under the price.

B) During the GFC, however, hybrids were sold down alongside equities
amid the widespread fear in financial markets of the risk that an issuer of the hybrid could find itself in a credit squeeze.

C) Generally this was a risk that did not materialise; most hybrid holders
continued to receive income and the selloff was an excellent opportunity for most investors.

D) However, investors should always be aware the relationship between

risk and reward. As with any investment, a higher return indicates a commensurate increase in risk. The key for investors is to avoid businesses that are unable to service their debt obligations.

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E) When debt market is high that time hybrid instrument is act like best
equity share and when equity market is on low it is act like best debt.

F) A focus on investing for income has led some investors to turn to hybrid.
These instruments present an alternative source of income, typically offering returns above cash.

G) Small retail investors looking to earn a higher rate above bank deposits
are limited in choice. Hybrid securities provide investors with the ability to do this. H) These securities are listed, so unlike a fixed term deposit, they can be sold on market if access to the principal is required, without incurring break fees.

I) It can provide regular distributions. If they are floating rate, distributions

will change with movements in interest rates. If fixed, interest payment will be the same for the entire term.

J) They can have potential tax benefits for some holders, as some pay
franked distributions. However, the tax advantage is often priced in.

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CHAPTER 5: CLASSES, PURPOSE & INNOVATIVE HYBRID FINANCING

1. CLASSES OF HYBRID SECURITIES

The determination of equity credit for any given security is based on that instruments specific features when compared/contrasted with the characteristics of equity: no maturity, no ongoing payments and deep subordination. Below is a brief overview of the major classes of hybrid securities from the context of features that typically warrant equity credit.

1. Traditional Preferred Stock:

Generally viewed as the original form of a hybrid security, preferred stock pays a stated dividend yield; much like the interest rate paid on bonds, but is unlike common stock in that it typically does not confer voting rights. Holders of preferred stock also have certain preferences or priorities over holders of common stock as to dividends and/or distribution of assets in the event of bankruptcy or liquidation. Preferred stock is issued directly by a holding company or operating company and can include equity-like features such as: Perpetual maturity, with no put options that present refinancing or repayment risk; Ability to defer ongoing payments; and Deep subordination, senior only to common stock. While some forms of preferred stock may receive nearly full equity credit, such as a perpetual noncumulative issue, other forms may not receive any equity credit. For example, issues with a stated duration and a short time to maturity expose the
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issuer to refinancing or repayment risk. The issuer also may elect to replace these deeply subordinated obligations with securities having a more senior claim in the overall capital structure. Also, for lower-rated companies, there is a risk that the organization may not be able to issue new securities to repay maturing issues.

2. Convertible Securities:
Convertible securities typically can be converted into shares of a companys common stock. For this reason, the issuance of convertible securities typically is seen as managements readiness to issue equity in the future. In general, these instruments can be grouped into two broad categories: mandatory conversion and optional conversion. In a traditional, mandatorily convertible security, the conversion formula is fixed; that is, the instrument automatically converts upon maturity into common stock based on a fixed price. Such instruments are equity-like since there is no obligation to return cash to investors at maturity. Furthermore, equity benefit increases progressively as maturity approaches, particularly if it is clear that the equity will remain a permanent part of the issuers capital base. In such cases, these securities may receive close to 100% equity credit within two years of conversion. Securities with a floating exchange rate are viewed as more debt-like. Other variations of mandatorily convertible securities include those that convert to a: Fixed number of common shares when issued, which protects the issuer from potential earnings per share dilution; and Number of shares that equals the principal amount owed to the investor, which may expose the issuer to significant earnings per share dilution should its stock price become depressed at the time of maturity. In general, a convertible security issue allows the issuer to benefit by offering lower dividend or interest rates, which enhances the issuers fixed-charge coverage
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ratio. Typically, optionally convertible securities can convert to a fixed number of common shares at the option of the investor. Without the call feature, it is unlikely that investors would forego the benefit of continuing to receive dividend payments on in the money securities. Key features of optionally convertible securities typically include: MaturityIts automatic conversion to common shares from issue makes it closely resemble common equitys no maturity characteristic, but while these securities typically do not have a repayment issue, they represent a subordinated claim in the event of default or cross default. Dividend or ongoing cash payments can be deferred. Such securities are subordinated within the capital structure.

3. Trust Preferred Securities:

Trust preferred securities, which include issues such as MIPS (Monthly Income Preferred Stock), QUIPS (Quarterly Income Preferred Stock) and TOPRS (Trust Originated Preferred Redeemable Stock), have the characteristics of both debt and equity instruments. These hybrid securities allow the issuer to make tax-deductible interest payments, which reduce the issuers cost of capital while also providing equity-like benefits similar to traditional preferred stock. Trust preferred securities generally are issued by a special-purpose trust created by the parent company. The trust lends proceeds to the parent through a subordinated loan that is junior to all other debt of the parent. The terms of the preferred securities match the terms of the underlying subordinated loan. Payment obligations of the trust typically are ensured not by a single guarantee, but through several agreements and by the terms of the debt securities
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that the trust holds. The agreements normally include a guarantee and an expense undertaking from the parent company; the trust indenture for the debt securities the trust holds; and the trust declaration of the trust itself. Typical key features include: A long maturity, between 20 and 40 years, with an issuer call option after five years. As such, it is an obligation that must be repaid from cash flow or refinanced. Dividends are deferrable, subject to suspension of common dividend, for up to five years without triggering a default. Deferred amounts accumulate, accrue interest and must be paid before resuming common dividends or at the end of the limited deferral period. Subordination to all debt obligations of the parent and on parity with other directly issued trust preferred. Due to the loan structure underlying the issued security, it has a more senior claim in liquidation to preferred stockholders. Default triggers where, as a debt claim, it is an obligation that could become due immediately in the event of a default, cross default, bankruptcy filing or other form of reorganization. Also, the existence of a call option would raise the possibility that the instrument could be replaced in the future with a new issue, with no guarantee that the refinancing will be neutral with respect to senior creditors in the issuers capital structure.

4. Surplus Notes:
In the United States, surplus notes typically are treated as policyholders surplus from a regulatory perspective. The issuance of surplus notes can enhance an

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insurers capacity to write business while at the same time lowering policyholders financial exposure through structural subordination. Surplus notes that A.M. Best views as equity-like are: Long term, typically having a stated maturity of 10 to 30 years; Subordinate to policyholders, claimants, beneficiary claims and other classes of creditors; and Subject to regulatory approval for all interest payments and principal repayments. This feature allows regulators to restrict payments if the insurers financial health deteriorates, without it being a default for the insurer.

2. PURPOSE OF HYBRID FINANCING

The concept of Hybrid Financing has been developed to enjoy the positive factors of both the equities and debt instruments. The residual claim is related to the equities. If someone is holding shares of a particular company then it is obvious that the person would enjoy some special rights regarding the cash flow and the assets. At the same time, the shareholder of the company is also entitled to play an important role while making business decisions.

Debt instruments are totally different from equities. These instruments are used by the major companies to arrange a kind of loan for the development of the company. The debt instruments do not provide the right to take part in the management of the particular company. But at the same time, the debt instruments confirm a permanent claim on the assets of the company.
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3. INNOVATIVE HYBRID FINANCING

Innovative hybrid financing is one popular method of hybrid financing. A hybrid debt security is a form of debt security, which is blended with derivatives like swap, forward or option. Previously, the most popular type of hybrid security was the convertible debenture or convertible bond. In the earlier part of 1980s, nevertheless, a unique category of hybrid securities achieved a lot of recognition, specifically in the United States. The distinguishing aspect of this type of securities is that the returns are associated with a number of common economic variable quantities, for example, commodity price, foreign exchange rate, rate of interest, share market index and many others. The hybrid securities are usually fundamental tools that are utilized for handling risk. Hybrids can be categorized into the following types:

Hybrids for handling commodity risk: Oil-indexed bond, which was issued by Standard Oil in the year 1986. This blended a zero coupon bond along with a call option on oil with similar maturity period.

Hybrids for handling foreign exchange risk: Dual currency bond, which was issued by Philip Morris Credit in the year 1985. The coupon payments were disbursed in Swiss francs and the principal was disbursed in United States Dollar.

Hybrids for handling interest rate risk: Inverse floating rate notes. The Student Loan Market Association or Sallie Mae issued this hybrid security in the year 1986. They were also known as yield curve notes. These notes can be broken down into two portions, i) a plain vanilla interest rate swap and ii) a variable rate bullet repayment note.
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Hybrids for diminishing the differences between bondholders and stockholders: Variable rate, rating sensitive note. This was issued by Manufacturer Hanover in the year 1988.

There are two principal financial reasons behind the acceptance of hybrid financing and they are the following:

They play an important role, which makes the market more comprehensive They offer regulatory or tax benefits

The key parameters to monitor for hybrid securities:

There are several factors one should be familiar with prior to investing in these hybrid securities. A. Running yield This is the yield of the security based on its market value. It is the anticipated income for investing in the security, expressed as a percentage based on the market value of the security at any moment in time.

B. Margin Margin is the spread over a certain reference rate that a hybrid is trading. This is in effect the running yield expressed in terms of a margin over bank bills. If the hybrid security pays a floating rate, the reference rate is usually the 90-day BBSW rate. In general, the lower the credit rating of the company, the higher the margin over the reference rate the issuer has to pay to entice investor to hold their

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securities. A lower credit rating is perceived to mean higher risk and investors have to be compensated for holding a higher risk security.

C. Credit rating Credit ratings can assist potential investors to form a view of the creditworthiness of the corporation and its associated cash generation assets, and compare them with other similar assets across different corporations. In general, the margin above the reference rate of a corporation and its associated securities decreases as the credit rating increases.

D. Duration to conversion, step up or redemption Once issued there is a point where the hybrid is reset for conversion, redemption or a distribution step-up. Thus, while the current running yield may be an important parameter to monitor, as noted above, the yield after the reset date is also critical, especially so if this date is less than two years away.

E. Liquidity The liquidity of the hybrid securities is often directly correlated to the credit rating and size of the issuing company. Liquidity often means that the larger issues of hybrid securities tend to trade at close to fair value. Smaller issues with less liquidity tend to trade at discounts to fair value. F. Frequency of dividend payment Most of the floating rate hybrids either pay income quarterly or semiannually. There should be a slight preference for investors to seek those hybrids that pay quarterly distributions as the income can be compounded in
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the holders control. In an environment where the cash rate is rising, having the rate of return reset quarterly is more advantageous.

G. Balance sheet Perhaps the most critical parameter with respect to a hybrid security is the amount of debt that a company is carrying. The lower the net debt to equity ratio, the higher probability the hybrid will not suffer from capital loss due to it trading as a debt-type security. As long as the underlying company is profitable, enabling it to service its debt obligations, the company is obligated to pay distributions to their hybrid securities owners.

H. The reputation of the corporation We have also observed that the more well-established the corporation, the better it will be at managing the interest of the hybrid securities holders. This is a qualitative measure and results in a quality issuer wanting to continue to protect their reputation or investment rating.

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Data Analysis of Hybrid Instruments:Percentage of Top-Level Bank Holding Companies with Tier 1 Hybrid Instruments, 1997-2010.

A few very large bank holding companies account for most of the value of all Tier 1 hybrid capital instruments. Specifically, the 20 largest bank holding companies with more than $100 billion in assets accounted for 85 percent of bank holding companies Tier 1 hybrid capital as of December 2010 and the four largest companies accounted for over 50 percent. As figure 4 shows, the amount of hybrid instruments included in Tier 1 capital has grown significantly since 1997. Although the total amount grew as institutions assets increased, the share of hybrid capital instruments in Tier 1 remained relatively consistent over time for the largest institutions. For example, in 1997, bank holding companies with more than $100 billion in total assets that included hybrid instruments in Tier 1 had a total of $6 billion of these instruments, or an average of 16 percent of the companies total Tier 1 capital. By 2010, institutions of this size held $133 billion in hybrid instruments, but the average percentage of their total Tier 1 capital had fallen slightly to 14 present.
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CHAPTER 6: KEY FACTORS AFFECTING STRUCTURE OF HYBRIDS & RECENT TRENDS

1. WHAT ARE SOME OF THE KEY FACTORS THAT AFFECT THE STRUCTURING OF HYBRIDS? The way in which a hybrid security is structured is largely affected by commercial factors, rather than legal ones, in particular:

for regulated financial entities, capital adequacy requirements imposed by Authority;

for entities with a credit rating, the level of "equity credit" that ratings agencies will attribute to the security (i.e. the extent to which the ratings agency will treat the hybrid as equity rather than debt);

the accounting treatment of the hybrid; the taxation treatment for both the issuer, including whether distributions are deductible or whether they can be franked, and the investor;

the issuer's financial position and its existing capital structure and debt facilities; and

Investor demand for particular types of products (which in turn may reflect prevailing economic and market conditions).

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2. RECENT TRENDS IN STRUCTURING OF HYBRIDS

Recent experience suggests that hybrid securities which have structural features closer to corporate bonds than ordinary equity are becoming increasingly popular in Australia amongst corporate issuers. Of the five hybrid issues since October 2011 by non-financial issuers, four (Woolworths, Origin Energy, Tabcorp and AGL Energy) have involved the issue of slightly varied forms of unsecured, subordinated notes which:

pay cumulative, unfranked, quarterly floating rate distributions of between 3.25% and 4.00% above the bank bill rate;

provide for deferral of distributions either at the discretion of the issuer or mandatorily where there would be a breach of interest cover or leverage ratios for a maximum of 5 years;

have an initial call date of between approximately 5 and 7 years, after which the margin will "step-up" by 0.25% (Tabcorp and AGL Energy) or 1.00% (Woolworths and Origin Energy) if the securities are not redeemed;

provide between 50% and 100% equity credit by Standard and Poors until their initial call date, when they will cease to have equity credit;

do not provide holders with any rights to convert their notes into ordinary shares of the issuer;

restrict redemption of the notes in certain circumstances unless the issuer has issued similar securities or ordinary shares prior to redemption; and

Rank above the ordinary shares of the issuer but behind all other forms of secured and unsecured creditors of the issuer.

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We expect there will be a continuing trend towards this type of hybrid which has primarily debt characteristics but provides some equity credit for rating purposes.

How Do You Access Hybrid Securities?

Large companies, including financial institutions, life insurers and general insurers are the dominant issuers of hybrid securities. When hybrid securities are offered to investors for the first time, it is usually through a float or what is called an Initial Public Offering (IPO). This process occurs on the primary market with the entity issuing a prospectus to potential investors. Organisations using hybrid securities to raise capital typically engage stockbroking firms to promote a float and distribute the prospectus to potential investors. If you wish to buy hybrid securities in a float you should first review their prospectus, then fill out the attached application form specifying the number of securities you wish to buy and send it with your payment to the issuing entity, or lodge it with a participating broker, before the application deadline. The price of a hybrid security issued in a float is specified in the prospectus and is usually $100. The benefit to Investors who purchase hybrid securities in an IPO is that they do not incur brokerage costs, making IPOs a great way to access hybrids at low cost. Once issued in the primary market, hybrid securities then trade on the secondary market and depending on supply and demand factors and the credit quality of the issuer, trading can be either highly liquid or extremely illiquid.

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Factors that can impact prices:

Changes in credit spreads: A credit spread is the interest rate

differential between a benchmark interest rate such as a government security and a non-government security. Credit spreads can change with changes in actual risk or perceptions of risk. A higher spread implies higher risk. For example, if there are concerns about the financial stability of banks, the spreads on bank-issued securities will widen. This is the same as saying prices for those securities will fall or yields will increase. This may adversely impact bank hybrid prices.

Changes in interest rates and interest rate expectations: Fixedrate security prices will be impacted by interest changes.

Pricing of alternative investments: If, for example, competition for

bank deposits intensifies and rates increase, this makes an investment in a riskier security such as a hybrid less attractive. If, for example, sentiment towards equities improves and the equity markets run, this may see a switch from income-type investments into growth-type investments.

The financial position of the issuer and/or peers: A change in the

financial condition of the issuer can impact its ability to pay distributions or repay principal and will also impact the price. For example, if an issuer or a peer breaches a debt covenant, this would adversely impact the price. If that issuer conducts an equity raising, this could be positive for the security price as it would improve the issuer's financial position.

Conditions specific to the security: For example, a security

approaching maturity is likely to trade closer to face value if redemption or

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conversion is likely. If such a security is unlikely to satisfy redemption or conversion conditions, the price would move away from face value.

Change in regulation/legislation: Changes to regulation may make it

favourable or less favourable to hold an existing security.

Corporate activity: Income securities often have acquisition trigger

events, which can see them being redeemed early if there is a takeover. For a security trading below face value, such an event would see the price rise.

Liquidity: Securities with low liquidity may trade at a lower price than an
equivalent security with higher liquidity.

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CHAPTER 7: CASE STUDIES & LIMITATION

1. HYBRIDS: CASE STUDY

1.HITTING IT OUT OF THE PARK: BANK OF AMERICA CORPORATION HITS

HYBRID SECURITIES are securities that have some equity characteristics and some debt characteristics. The securities are structured to obtain favorable equity treatment from ratings agencies, permit issuers to make tax-deductible payments, and qualify as Tier 1 capital for bank holding companies. The benefits of a hybrid security depend on its equity-like or debt-like characteristics. From a ratings agency perspective, the more equity-like the hybrid, generally, the more favorable the treatment for the issuer. From a tax perspective , the more debt-like the hybrid, generally, the more favorable the tax treatment for the issuer. Success lies in structuring a single security meeting these seemingly contradictory objectives. It helps if the security has a catchy name, too.
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In February 2007, we worked with Bank of America Corporation and Bank of America Securities LLC in connection with the issuance of approximately $1.5 billion of hybrid securities, called Hybrid Income Term Securities, or HITS. HITS are an example of a hybrid unit transaction, which pairs two securitiesa perpetual non-cumulative security and a forward stock purchase contract. The forward stock purchase contract commits the issuer to deliver, and investors to purchase, a variable number of shares of perpetual preferred stock of the issuer some time from issuance. In this case, Bank of America Corporation, a bank holding company, issued through a trust a hybrid income term security. See Figure 1. The hybrid income term security consisted of a re marketable junior subordinated debt security paired with a five year forward stock purchase contract on Bank of America perpetual preferred stock. The trust holds re marketable junior subordinated notes issued by Bank of America. The HITS and the perpetual preferred stock have an identical coupon. Interest on the re marketable junior subordinated notes is deferrable and is cumulative. After the offering, investors may exchange HITS, together with certain U.S. Treasury securities, for Treasury HITS and Corporate HITS by substituting pledged U.S. Treasury securities for the pledged notes. A holder of Treasury HITS and Corporate HITS may convert back into HITS at any time. See Figure 2. After five years, the subordinated notes can be remarketed, and the proceeds from the remarketing will be used to exercise the forward contract to purchase the non-cumulative perpetual preferred stock. If the notes are not remarketed, then the trust can deliver the notes to the issuer as payment for the non-cumulative perpetual preferred stock. The HITS issuance incorporated several hybrid structuring innovations. The offering was structured in two tranches, a series of floating rate HITS and a fixedto floating rate HITS. The HITS also included call provisions permitting the issuer to redeem the security upon the occurrence of certain events, including an
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investment company event and a capital treatment event. The securities also included a call upon the occurrence of a tax event, which included a make-whole premium in the fixed-rate tranche. Consistent with the newest generation of hybrids, HITS contained an alternative payment mechanism that required that deferred distributions be paid only out of proceeds from the issuance of more junior or parity securities. HITS also incorporated a replacement capital covenant for the benefit of holders of Bank of Americas more senior debt securities. The contractual replacement language requires that funds for redemption be from proceeds of the issuance of common stock, other perpetual or long-dated noncumulative preferred stock, or certain other allowed instruments received within 180 days of redemption. Redemption is subject to regulatory approval. Standard & Poors views the HITS as two separate transactions. The issuer benefits from payment deferral; although Standard & Poors notes that the term of the notes is too short to obtain equity credit. However, the non-cumulative perpetual preferred stock has strong equity-like characteristics. Moodys assigned the HITS D basket treatment. On maturity, the securities receive a strong ranking. On ongoing payments, distributions are deferrable and must be settled using common stock. The forward contract obligates Bank of America to sell non-cumulative perpetual preferred stock to holders in five years. The perpetual preferred is immediately callable subject to binding replacement language. As to ongoing payments, the HITS receive a moderate ranking. On loss absorption, the HITS rank strong. From a tax perspective, the components (the note and the forward contract) are treated as two separate instruments. Interest on the note is deductible for federal income tax purposes in reliance on Revenue Ruling 2003-97, addressing an investment unit comprised of a debt instrument and a forward contract to buy common stock.

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2. CASE STUDY - US BANCORP HYBRID BOND

Hybrid securities, which combine the benefits of equity and tax-deductible debt, have taken off because they are partly treated as equity by credit rating agencies and they do not weigh on credit ratings as traditional debt issuance can. Hybrid bonds combine the regular interest payments of bonds with features of equity, including ultra-long or perpetual maturities and the opportunity to defer coupon payments. These products have been around for a while, but Moody's gave the bonds a boost when it clarified its position by issuing guidelines on how it would treat the products. 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. This means 75 percent of the funds raised are treated as equity.

Demand for the securities is being driven as investors reach for more yield than traditional corporate bonds. Hybrids are riskier than traditional bonds because they rank lower in a company's capital structure and their income is not as secure. One cloud came in March 2006 when an insurance regulator classified a hybrid sold by Lehman Brothers as common equity, making it more expensive for insurance companies to hold.

The Lehman-issued enhanced capital advantage preferred securities, or Equity capital, was classified as common equity by the National Association of Insurance Commissioners. The NAIC is responsible for assigning and valuing securities owned by state regulated insurance companies. Lehman said that it
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disagrees with the classification, arguing that the instrument has many debt-like features and should be classified as "worse case" preferred equity, according to sources that listened to the call.

It is more expensive for insurers to hold securities classified as common equity because they are required to pay a 15 percent capital charge against the security, which is significantly higher than charges for holding preferred stock or debt. Insurers are estimated to hold roughly between 10 percent and one third of hybrids sold.

Most of the issues are from financial institutions, but a few corporations have taken advantage of the dual-benefit instruments. Example: a $450 million issue for toolmaker Stanley Works, a structure dubbed an Etrups, or Enhanced Trust Preferred Security. Hybrids have also caught on outside the US -- in Europe (Porsche, Casino), Asia, and even in Eastern Europe. For example, Mol, the Hungarian oil and Gas Company, has issued 610m of hybrid bonds with speculative-grade ratings that can be converted into shares in the company. The Mol perpetual notes are priced with a coupon of 4 per cent and a conversion premium of 30 per cent. The bonds can be converted into the company's shares after between five and 10 years, while the bonds can be bought back by the issuer after 10 years. Bond investors are also entitled to any dividend payments from Mol.

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2.Limitations
Before concluding, it should be useful to point out some of the potential limitations of the study. There was a lack of numeric data or statistics related to this research question, nothing of what is needed is available. Even the data was collected from various financial related web sites & books, but the data is not really enough useful or enough relevant to be used in this research. Qualification requirement used in the project may differ from investor to investors. The data taken during the project study may not represent the realistic picture. Hence there may be margin of error. Small sample size taken at convenience might have affected the result of the study. Existence of biases in the respondent mind. Most of authorized people working in the security market are afraid to disclose their strategies in investing in hybrid instrument.

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CHAPTER 8: CONCLUSION, BIBLIOGRAPHY & WEBLIOGRAPHY

1. CONCLUSION
Hybrid instruments are a common way to finance a corporation. With these instruments it is possible to be flexible and adjust to the exact demands of the issuer and the investor. Every tax jurisdiction has its specific way to fulfill this task. It is therefore possible that in the international field one country can treat a specific instrument as equity while the other country treats it like debt. This qualification conflict can either lead to a double taxation or a double non taxation of the yields in question. If a country treats an instrument as equity there are mechanisms that mitigate or eliminate the double taxation that would result from a foreign and domestic taxation of the same income. The exemption method simply excludes the dividends from a domestic taxation while the direct credit method takes the foreign withholding taxes into account when computing the payable taxes. With the indirect credit method it is even possible to credit the foreign corporate taxes if special requirements are fulfilled. An instrument that is qualified as debt in a foreign country and as equity in the domestic country causes a different computation of the indirect credit and the foreign tax credit limitation. Most importantly, hybrid instruments that are qualified as debt in the foreign country cannot lead to a tax cut because no foreign corporate taxes have been paid. It is therefore necessary that the foreign corporation pay taxes preferably for other profits that are not distributed.
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2. BIBLIOGRAPHY

1) FUNDAMENTALS OF FINANCIAL INSTRUMENTS: AN INTRODUCTION TO STOCKS, BONDS, FOREIGN EXCHANGE, AND DERIVATIVES (THE WILEY FINANCE). 2) FINANCIAL INSTRUMENTS & FINANCIAL MARKETS. 3) HYBRID FINANCIAL INSTRUMENTS. 4) HYBRID CAPITAL SECURITIES. 5) HYBRID SECURITIES & FINANCIAL MARKET.

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3. WEBLIOGRAPHY

www.investorwords.com en.wikipedia.org www.etoro.com uk.practicallaw.com www.afrsmartinvestor.com www.lexology.com www.taiwanratings.com www.moneysmart.gov.au finance.mapsofworld.com www.ehow.com www.iflr.com www.squiresanders.com www.managmentparadise.com www.scribd.com

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