Time for firms to bond with hybrids
One of the largest trends to emerge in finance in recent times is that of hybrid bonds. Peter Williams explains exactly what they can offer
The City is always keen to sell a new trend where there is money to be made, and one of the biggest fashion items in the City has been hybrid bonds. Except, while banks have been busy talking about hybrid bonds, no UK corporate – at least at the time of writing – has issued them. UK finance directors have stood back and watched European corporates take this route. The most recent was car maker Porsche, which issued a $1bn hybrid in January this year.
Banks are puzzled over UK plc’s lack of enthusiasm. Many reasons have been mooted – apart from the more expensive fees that the banks are looking to charge compared with normal debt issues – including the idea that finance directors do not want to be the first ones to take this step.
Hybrid bonds are complex. They are more properly described as debt instruments with equity characteristics built into the underlying contract. Like other bonds, hybrids have that killer benefit of tax-deductible interest, but potentially have less impact on credit ratings because of their equity characteristics.
The building blocks for hybrids have been transplanted from the financial institutions’ bond market. Hybrids made the transition from the financial sector when Moody’s reassessed its approach and gave credit for the equity characteristic of a hybrid issued by a non-financial company. For Moody’s and other agencies, the precise equity credit given will depend on the terms of the bond.
To see how hybrid bonds are treated at the moment we have to look to IAS32 Financial Instruments: Presentation. To quote from a senior equity analyst: “Under IAS32, hybrids will usually be treated as debt. However, if the equity characteristics are sufficiently strong, it will be treated as equity. This can make analysing companies with such financing in place more difficult.”
A further problem arises if the hybrid is swapped from fixed to floating. Experts suggest that under IAS39 Financial Instruments: Recognition and Measurement, fair value hedge accounting would be available if the hybrid was classified as debt, but not if it is classified as equity.
The IASB itself has recently looked at the issue through its International Financial Reporting Interpretations Committee (IFRIC). It looked at the contractual terms of two financial instruments. One contained no obligation ever to pay dividends or to call the instrument – IFRIC called it equity under IAS32. The second paid dividends if interest was paid on another (linked) instrument. IFRIC called that linking an obligation and said it should be classified as a liability.
Whether it gets what it expects remains to be seen. After all, the major selling point of a hybrid is its chameleon-like appearance. Lose that and we are back to debt. How to account for hybrids has echoes of a forgotten UK standard FRS4 Capital Instruments. FRS4 (which has now been replaced by FRS25 and FRS26) tried to draw the line between debt and equity. That line seems increasingly blurred. If the City thinks it can start playing fast and loose with debt and equity again we may see a similar reaction from those who hold the standard setting strings today.