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Hybrid bonds

Hybrid bonds are subordinated bonds from the non-financial segment that share certain characteristics with equity. The yields of hybrid bonds are significantly higher than those paid by the senior bonds from the same issuer.

The risk/return profile of this asset class is located on the continuum between equities and senior bonds. Hybrid bonds either come with very long maturities or have no end of maturity at all. The issuer has certain rights of termination during the life of the bond.

Hybrid bonds do not offer a fixed pay-out; the rate of return is linked to the earnings and business situation of the issuer. This means that coupon payments may be suspended, but they are typically recovered as soon as a dividend is paid out.

Coupon payments are fixed for a period of five to twelve years, which is followed by a period of variable rates. If the bond is not redeemed at the initial call date, the coupon turns variable. The percentage of the coupon consists of a referential interest rate and a risk premium. At every new call date, the risk premium on the referential interest rate increases, which incentivises the issuer to redeem the bond as early as possible.

Hybrid bonds come with numerous benefits for issuers. Hybrid issues are less costly than an IPO or a capital increase via shares. In contrast to dividends, the issuer can deduct the coupon payments for tax purposes, and hybrid capital supports the rating of senior bonds. Most rating agencies include up to 50% of hybrid bonds in the issuer’s equity ratio.

Special issuer rights of hybrid bonds

Subordinated seniority

  • Bonds of subordinated seniority, or subordinated bonds, or junior bonds, are serviced only after all other senior debt (i.e. debt that is not subordinated or junior) has been serviced in the event of insolvency.
  • Therefore, in the event of insolvency the risk of loss is higher for subordinated bonds than it is for senior bonds.

Coupon moratorium

  • The coupon payments of the hybrid bond may be suspended but have to be recovered if the issuing company distributes e.g. dividends to the shareholders.
  • The details about a possible moratorium of the coupon are laid down in the prospectus of the bond.
  • Hybrid bonds do not offer a fixed pay-out; the rate of return is linked to the earnings and business situation of the issuer.

Right to terminate

  • Typically, the issuer of a hybrid bond can call it prior to the first call date under certain conditions.
  • The specific conditions are laid down in the prospectus of the bond (e.g. in case of a change of accounting standards, ownership structure of the company, or the classification of the bond as equity by rating agencies).

Extension of maturity

  • The issuer of a hybrid bond has the right (but not the obligation!) to terminate the bond on the first scheduled call date.
  • Typically, issuers make use of their right to call the bond on the first call date, because otherwise the coupons would increase ("step-up coupons).
  • If the issuer against expectations does not terminate the bond, its maturity extends in accordance with the terms and conditions of the bonds.
  • As a result, the average weighted maturity of the bond may increase.

Termination rights particular to hybrid bonds

Rating Event Call/Capital Event Call

  • The issuer has the right to terminate early if the classification of the hybrid bond as equity by rating agencies has deteriorated.
  • Termination depends on the equity ratio, not on the issuer rating (at least not directly).

Change-of-Control (CoC) Calls

  • When the bond is not terminated in the course of a change of ownership structure, the coupon increases by 500bps.
  • Please note:
    • CoC event: The exact definition is based on local takeover law and
    • Rating downgrade or withdrawal as a result of and within a certain time window after CoC.

Accounting Event Calls

  • The issuer can terminate the bond if it is no longer classified as equity or financial debt in accordance with the applicable accounting standards. Most bonds have a call price of 101 in such case.

Tax Events Calls (Gross Up/Tax Event)

  • The issuer can terminate the bond
    • in the event of an amendment to the tax code and if the issuer has to compensate the bond holders for possible tay losses, or
    • if the cost of capital for hybrid bonds are not deductible for tax purposes any longer due to ameridments to the tax code.

Clena-up Calls

  • Termination if the volume outstanding falls below a benchmark size (10-25% of issue volume).