Hybrid Securities

Structuring, Pricing and Risk Assessment

Kamil Liberadzki, Marcin Liberadzki

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137589712
• Topic: Business
• Subtopic: Financial Services
• Index: Business

Hybrid capital securities or 'hybrids' offer various benefits. They offer flexibility equity without shareholder dilution, provide protection to senior creditors, are a stable source of long-term funding for healthy companies, and help insurers and banks meet regulatory and rating agency capital requirements. Risks and features of hybrid securities are expressed in the credit spread of some relatively new financial instruments, but no structural fundamentals exist for to price hybrids precisely.This book proposes a model for the pricing of hybrids. It begins by explaining the concept of hybrids as well as their equity- and debt-like characteristics. Different types of hybrids are presented, including preference shares, convertible bonds, contingent convertibles (CoCos) and bail-in bonds. The authors then present analysis of regulatory regimes' impact on hybrids. They discuss the types of hybrid bonds that are contemplated in the Capital Requirements Regulation (CRR) and Banking Unionmechanism. They then present an in-depth examination of hybrids pricing and risk assessment techniques. The book provides a comprehensive analysis from mathematical, legal and financial perspectives in order to look at relatively new financial instruments and address problems with the pricing models of hybrids which are as yet unsolved.

1

The Definition of Hybrid Securities

1.1.

Introduction

Hybrid securities are fixed income instruments that combine elements of shares and corporate bonds. They are considered to be placed somewhere in between debt and equity, or ‘in the debt–equity continuum’ as credit rating agencies name it. The exact place of each individual hybrid in such a continuum is determined based on each of its characteristics: maturity, subordination and character of coupon deferral. These criteria are commonly used by credit rating agencies to grant an equity credit of a given security. High equity credit marks an instrument that possesses greater loss-absorption capacity, as is typical for equity instruments. Hybrids are qualified as subordinated debt, which means that – in case of liquidation or winding-up of the issuer – they are ranked below all other debt but above equity.

Preferred shares and subordinated bonds (corporate hybrids) are the two most common types of hybrid securities. Preferred shares are equity instruments that – in case of an issuer’s liquidation – are ranked junior to all debt but senior to the common equity of the issuer, while subordinated bonds are bonds structured to obtain certain features of capital instruments and rank pari passu with a firm’s junior subordinated debt (and, therefore, senior to its preferred stock).

Convertible bonds are considered to be ‘hybrid securities’, though some doubts arise as regards the correctness of this classification. A convertible bond is a debt instrument, which – at the holder’s option – may be converted into a capital instrument. One could therefore describe its nature as not ‘hybrid’ but rather ‘transforming’. Of course, it is possible that at least one of the instruments embedded in a convertible bond structure will be a hybrid security. This may happen both for a debt instrument and for the underlying capital instrument: a convertible bond may be equipped with some capital elements (like, say, perpetual maturity) and the underlying capital instrument may well be a preferred share. In such a case, the hybrid character of a convertible bond should not be questioned. Most frequently, however, a convertible instrument is a simple debt security (without any capital features) that can be converted into a simple equity security (without any debt features). Is such a conversion option sufficient to classify a convertible bond as a hybrid security? In legal terms, the correct answer would be to identify convertibles rather as equity-linked notes (Trapnell, 2010). The hybrid nature of convertibles is more visible in terms of financial analysis, where their pricing is affected by the performance of underlying equity. Besides, convertible bonds are given some special treatment by the financial regulator, which is quite similar to the approach applicable to equity instruments. This may be regarded as an argument in favorem the hybrid character of convertible bonds, despite the fact that tested with the aforementioned debt–equity continuum criteria, convertible bonds will be regarded simply as debt instruments.

It is quite the opposite when discussing a specific type of convertible bonds: contingent convertibles (CoCos). CoCos are subordinated hybrid securities with a fixed coupon and an automatic conversion provision. This provision enables banks to exchange bonds for common stock, subject to a breach of a conversion trigger set forth at the inception of the issuance of the bonds. In the event the conversion trigger is not breached, CoCo bonds remain as coupon-paying, normal subordinated debt securities to retire at maturity (unless they are perpetual bonds). A conversion is not an option at the discretion of a bondholder but is forced when regulatory capital fails to meet a predetermined level. This unique feature provides to the CoCo bonds the loss-absorption capacity on a going-concern basis, a regulatory goal that seems not to have been effectively implemented under the pre-crisis legal framework of tier-based capital structures. Thus, CoCo bonds provide buffer capital to a bank at a time of distress but before potential insolvency (i.e. on a going-concern basis). Of late, one must consider loss-absorption capability to constitute a fourth dimension of the debt–equity continuum and therefore CoCos may be regarded as hybrid securities. The use of CoCos for bank recovery and resolution purposes is a vital element of a Bank Recovery and Resolution Directive1 (BRRD) legal framework and will be discussed in detail later in this book.2

A more extreme construction of loss absorption is designed in a write-down mechanism, where the occurrence of a predetermined event (stress-related) automatically triggers a write-down of a bond’s value. Such an automatic ‘bail-in’ executed in times of distress may rescue a bank from failure without a (heavily criticized) injection of taxpayer money into large financial institutions (bail-out). The burden of an institution’s failure is imposed on the bondholders, but the institution may continue to operate, averting disruption of the financial system. One may say that this write-down mechanism is somehow similar to that embedded in so-called ‘catastrophe bonds’ (or simply ‘CAT bonds’), which were originally designed by US reinsurers and were used to transfer to the insurance industry the risk of losses caused by natural disasters. The most recent developments in the structuring of CoCo bonds aim to reduce the severity of an automatic write-down of the bonds’ principal value, facilitating the discretionary write-up of the bonds once the financial situation of the issuing bank is no longer distressed.

The last, and the youngest, of the hybrid instruments is the bail-in bond. This category of bond covers all debt instruments that may share the burden of financial institution losses. The manner in which bail-in and Coco bondholders are engaged in the loss-absorption process differs. Holders of CoCos are rewarded with higher coupon rates because of the greater exposure to risk, whereas in the case of bail-in bonds, bondholders (as those who provided financial institutions with funding that allowed them to lend money imprudently) should absorb losses before the loss burden is transferred to taxpayers, for the sake of financial market stability. While a CoCo bond provides loss absorption on a ‘going-concern’ basis (it is triggered when accounting parameters signalize that the institution is facing financial stress), a bail-in bond is a ‘gone-concern’ instrument, as loss absorption is triggered when the point of non-viability (PONV) that marks an institution’s failure is reached. However, in section 7.3, it will be demonstrated that a bail-in trigger may be executed long before the soundness of a financial institution is questioned when the accounting triggers of a CoCo are set off.

1.2.

Core features of hybrids

1.2.1.

Financial and corporate hybrids

As already mentioned, each corporate issuer of debt may embed some equity features in the structure of an issued bond. Such bonds will fall into a broad category of corporate hybrids. It should be noted that once the hybrid market was developed, the terminology started to become more specific. Nowadays, the term ‘corporate hybrids’ refers only to hybrids issued by corporations other than financial institutions, while hybrids issued by financial institutions are referred to as ‘financial hybrids’ or have more specific names that refer precisely to the balance sheet item to which they correspond. For example, if a bank intends to issue a hybrid bond that would meet the criteria of Additional Tier 1 (AT1) capital under Capital Requirements Regulation3 and Directive4 (CRR/CRD IV) package, it would be referred to not as a corporate hybrid but as an AT1 financial hybrid. For the purpose of this book, the term ‘financial hybrids’ is used only to describe hybrid securities issued by financial institutions in general, while individual hybrids will be referred to in a manner that identifies their place in the tier structure of capital.

1.2.2.

Maturity

Maturity date of debt defines when the nominal value of a loan should be transferred back to the creditor. Common equity may be regarded as a ‘perpetual’ security, as it has no fixed maturity date. Corporate hybrids that have no fixed maturity date are referred to as undated or perpetual bonds (perpetuals). For example, a perpetual issued by the Lekdijk Bovendams water board in 1648 still continues to pay interest (Goetzmann and Rouwenhorst, 2005). Besides, bonds with a very long maturity (30 years and longer) are also considered to be hybrids, as they offer financing for a much longer period than the one usually assumed to constitute long-term financing (5–10 years). A common feature of many perpetuals and bonds with a very long scheduled contractual maturity is an issuer call option typically exercised five or ten years from the date of issuance. Market convention expects hybrids to be called on the first call date. Moreover, skipping the option is usually associated with negative consequences for the issuer: a higher interest rate (coupon step-up), a change of coupon payments from a fixed rate to a floating rate (fixed-to-float) or a change in the reference rate.5 These create for an issuer an incentive to redeem instruments at the call date, thus making a hybrid less equity-like. It is worth noting that in regulated industries regulatory approval is required for an instrument to be called and that such approval would only be granted if it is replaced with a comparable equity-like instrument.6

1.2.3.

Deferral

What regards a typical bond, any failure of the issuer to make scheduled coupon payments to investors results in his default, and investors are entitled to file for his bankruptcy. On the other hand, common equity instruments offer no scheduled payments, and the distribution of dividends to shareholders is subject to the discretion of the company board or the decision taken at an annual general meeting (AGM) of shareholders. Therefore, a lack of dividend distribution does not constitute a default and does not give rise to any claims of shareholders (subject to special accumulation rights of holders of the preferreds, as discussed above). At times of financial stress, a company may just cancel all dividend payments to shareholders to steer clear of dangerous waters. Such a solution would obviously be of no help in the event of a bond coupon cancellation.

Hybrid securities offer the issuer the ability to avoid making coupon payments in periods of financial stress, which is a key equity-like feature of a corporate hybrid. Coupon payment may be suspended (cumulative deferral) or even canceled (non-cumulative deferral), without threat of default. In such a situation, bondholders, acting as company creditors, bear the costs of the company’s difficult situation together with its beneficial owners – shareholders. Of course, hybrid holders must be protected against a situation where they would solely bear these costs. Dividend-blocker and dividend-pusher mechanisms address this threat by linking decisions on dividend and coupon distribution. In legal systems where decisions on dividend distribution are made not by management boards but by AGMs, the mechanism of look-back serves the same purpose.7

Another form of deferral is so-called Alternative Coupon Satisfaction Mechanism (ACSM). If the issuer is unable to pay coupons or dividends in cash it must satisfy hybrid holders by giving them common stock (or preference shares). Most ACSMs include a pledge by the issuer to attempt the market issuance of new equity (once or repeatedly) and to use the proceeds of any issuance to settle the applicable o...