Hybrid Financial Instrument

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,
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
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S E M V T . Y. B B I
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.
Why it matters?
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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
convertible bond holders to participate in the
company's stock price appreciation.
How are they different to equities?

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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 dividend 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.
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
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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;
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;
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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;
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
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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 equitycharacteristics
and some debt characteristics, have been popularfor over a decade. Hybrid
securities lie somewhere along theequity-debt continuum, but where exactly,
is the subject of greatdebate, and depends largely on the terms of the
instruments aswell as the provisions of applicable national laws. In fact, over
itslife, a hybrid security may exhibit different proportions of equity likeor
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.
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.
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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.
3. THE BENEFITS OF HYBRID SECURITIES
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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.
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
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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.
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
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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.
CHAPTER 3: TYPES
1. DIFFERENT TYPES OF HYBRID SECURITIES
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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.
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
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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.
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.
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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.
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.
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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.
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
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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
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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.
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,
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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
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 upequity 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
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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.
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
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to stock of the corporation.
CHAPTER 4: RISKS INVOLVED, & OBJECTIVES

1. RISKS INVOLVED IN HYBRID SECURITIES
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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
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.
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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.
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,
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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.
Historically, an issuer and its advisers sought to structure a

hybrid security that:
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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.
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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
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
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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
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.
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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.
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 forany given security is based on that

instrumentsspecific features when compared/contrasted with the characteristics of
equity:no maturity, no ongoing payments anddeep subordination.Below is a brief
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overview of the majorclasses of hybrid securities from thecontext of features that

typically warrantequity credit.
1. Traditional Preferred Stock:

Generally viewed as the original form ofa hybrid security, preferred stock pays
astated dividend yield; much like the interestrate paid on bonds, but is unlike
commonstock in that it typically does not confer votingrights. Holders of preferred
stock alsohave certain preferences or priorities overholders of common stock as to
dividendsand/or distribution of assets in the event ofbankruptcy or
liquidation.Preferred stock is issued directly by a holdingcompany or operating
company andcan include equity-like features such as: Perpetual maturity, with no
put optionsthat present refinancing or repayment risk;
Ability to defer ongoing payments; and
Deep subordination, senior only to commonstock.
While some forms of preferred stock mayreceive nearly full equity credit, such asa
perpetual noncumulative issue, otherforms may not receive any equity credit.
Forexample, issues with a stated duration anda short time to maturity expose the
issuerto refinancing or repayment risk. The issueralso may elect to replace these
deeply subordinatedobligations with securities havinga more senior claim in the
overall capitalstructure. Also, for lower-rated companies, there is a risk that the
organization maynot be able to issue new securities to repaymaturing issues.
2. Convertible Securities:
Convertible securities typically can be convertedinto shares of a companys
commonstock. For this reason, the issuance of convertiblesecurities typically is
seen as managementsreadiness to issue equity in thefuture. In general, these
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instruments can begrouped into two broad categories: mandatoryconversion and

optional conversion.
In a traditional, mandatorily convertiblesecurity, the conversion formula is
fixed;that is, the instrument automatically convertsupon maturity into common
stockbased on a fixed price. Such instruments are equity-like since there is no
obligationto return cash to investors at maturity.Furthermore, equity benefit
increases progressivelyas maturity approaches, particularlyif it is clear that the
equity will remaina permanent part of the issuers capitalbase. In such cases, these
securities mayreceive close to 100% equity credit withintwo years of conversion.
Securities with afloating exchange rate are viewed as moredebt-like.
Other variations of mandatorily convertiblesecurities include those that
convert to a: Fixed number of common shares whenissued, which protects the
issuer frompotential earnings per share dilution; and Number of shares that equals
the principalamount owed to the investor, which mayexpose the issuer to
significant earnings pershare dilution should its stock price becomedepressed at the
time of maturity.
In general, a convertible security issueallows the issuer to benefit by offering
lowerdividend or interest rates, which enhancesthe issuers fixed-charge coverage
ratio.Typically, optionally convertible securitiescan convert to a fixed number of
commonshares at the option of the investor. Without the call feature, it is unlikely
that investors would forego thebenefit of continuing to receive dividend
paymentson in the money securities.
Key features of optionally convertible securitiestypically include:
MaturityIts automatic conversionto common shares from issue makes
itclosely resemble common equitys nomaturitycharacteristic, but while
thesesecurities typically do not have a repaymentissue, they represent a
subordinatedclaim in the event of default or crossdefault.
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Dividend or ongoing cash payments canbe deferred. Such securities are

subordinated withinthe capital structure.
3. Trust Preferred Securities:

Trust preferred securities, which includeissues such as MIPS (Monthly Income
PreferredStock), QUIPS (Quarterly IncomePreferred Stock) and TOPRS (Trust
OriginatedPreferred Redeemable Stock), havethe characteristics of both debt and
equityinstruments. These hybrid securities allowthe issuer to make tax-deductible
interestpayments, which reduce the issuers costof capital while also providing
equity-likebenefits similar to traditional preferredstock.
Trust preferred securities generally areissued by a special-purpose trust
createdby the parent company. The trust lendsproceeds to the parent through a
subordinatedloan that is junior to all other debtof the parent. The terms of the
preferredsecurities match the terms of the underlyingsubordinated loan.
Payment obligations of the trust typicallyare ensured not by a single
guarantee, butthrough several agreements and by theterms of the debt securities
that the trustholds. The agreements normally includea guarantee and an expense
undertakingfrom the parent company; the trustindenture for the debt securities the
trustholds; and the trust declaration of thetrust itself.
Typical key features include:
A long maturity, between 20 and 40years, with an issuer call option after
fiveyears. As such, it is an obligation thatmust be repaid from cash flow or
refinanced.
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Dividends are deferrable, subject to suspensionof common dividend, for up to

fiveyears without triggering a default. Deferredamounts accumulate, accrue
interest andmust be paid before resuming commondividends 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
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
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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.
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.
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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.
Hybrids for diminishing the differences between bondholders and

stockholders: Variable rate, rating sensitive note. This was issued by Manufacturer
Hanover in the year 1988.
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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
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,
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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
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
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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.
Data Analysis of Hybrid Instruments:Percentage of Top-Level Bank Holding Companies with Tier 1 Hybrid
Instruments, 1997-2010.
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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.
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Conditions specific to the security: For example, a security

approaching maturity is likely to trade closer to face value if redemption or
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 somedebt characteristics. The securities are structured to obtain favorable
equity treatmentfrom ratings agencies, permit issuers to make tax-deductible
payments, and qualify asTier 1 capital for bank holding companies. The benefits of
a hybrid security depend onits equity-like or debt-like characteristics. From a
ratings agency perspective, themore equity-like the hybrid, generally, the more
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favorable the treatment for the issuer. From a tax perspective, the more debt-like
the hybrid, generally, the more favorable thetax treatment for the issuer. Success
lies in structuring a single security meeting theseseemingly contradictory
objectives. It helps if the security has a catchy name, too.
In February 2007, we worked with Bank of America Corporation and Bank
ofAmerica Securities LLC in connection with the issuance of approximately $1.5
billion ofhybrid securities, called Hybrid Income Term Securities, or HITS. HITS
are an exampleof a hybrid unit transaction, which pairs two securitiesa perpetual
non-cumulativesecurity and a forward stock purchase contract. The forward stock
purchase contractcommits the issuer to deliver, and investors to purchase, a
variable number of shares ofperpetual preferred stock of the issuer some time from
issuance.In this case, Bank of America Corporation, a bank holding company,
issuedthrough a trust a hybrid income term security. See Figure 1. The hybrid
income termsecurity consisted of a remarketable junior subordinated debt security
paired with a fiveyearforward stock purchase contract on Bank of America
perpetual preferred stock. Thetrust holds remarketable junior subordinated notes
issued by Bank of America. The HITSand the perpetual preferred stock have an
identical coupon. Interest on the remarketablejunior subordinated notes is
deferrable and is cumulative. After the offering, investorsmay exchange HITS,
together with certain U.S. Treasury securities, for Treasury HITSand Corporate
HITS by substituting pledged U.S. Treasury securities for the pledgednotes. A
holder of Treasury HITS and Corporate HITS may convert back into HITS atany
time. See Figure 2. After five years, the subordinated notes can be remarketed,
andthe proceeds from the remarketing will be used to exercise the forward contract
topurchase 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 noncumulativeperpetual preferred stock.
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The HITS issuance incorporated several hybrid structuring innovations.

Theoffering was structured in two tranches, a series of floating rate HITS and a
fixed-tofloatingrate HITS. The HITS also included call provisions permitting the
issuer toredeem the security upon the occurrence of certain events, including an
investmentcompany event and a capital treatment event. The securities also
included a call upon theoccurrence of a tax event, which included a make-whole
premium in the fixed-ratetranche. Consistent with the newest generation of
hybrids, HITS contained an alternativepayment mechanism that required that
deferred distributions be paid only out of proceedsfrom the issuance of more junior
or parity securities. HITS also incorporated areplacement capital covenant for the
benefit of holders of Bank of Americas more seniordebt securities. The contractual
replacement language requires that funds for redemptionbe from proceeds of the
issuance of common stock, other perpetual or long-dated noncumulativepreferred
stock, or certain other allowed instruments received within 180 daysof redemption.
Redemption is subject to regulatory approval.Standard & Poors views the HITS as
two separate transactions. The issuerbenefits from payment deferral; although
Standard & Poors notes that the term of thenotes is too short to obtain equity
credit. However, the non-cumulative perpetualpreferred stock has strong equitylike characteristics. Moodys assigned the HITS Dbaskettreatment. On maturity,
the securities receive a strong ranking. On ongoingpayments, distributions are
deferrable and must be settled using common stock. Theforward contract obligates
Bank of America to sell non-cumulative perpetual preferredstock to holders in five
years. The perpetual preferred is immediately callable subject tobinding
replacement language. As to ongoing payments, the HITS receive a
moderateranking. On loss absorption, the HITS rank strong. From a tax
perspective, thecomponents (the note and the forward contract) are treated as two
separate instruments.Interest on the note is deductible for federal income tax
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purposes in reliance on Revenue Ruling 2003-97, addressing an investment unit

comprised of a debt instrument and aforward contract to buy common stock.
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, includingultra-long or perpetual maturities and the opportunity to defer
coupon payments. These products have been around for awhile, 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
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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
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 necessarythat the foreign corporation
pay taxes preferably for other profits that are not distributed.
56 |
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.
57 |
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
58 |

Hybrid Financial Instrument

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Hybrid Financial Instruments

CHAPTER 1: INTRODUCTION, MEANING &

A hybrid financial instrument is an investment that blends characteristics of both