The Growth in the Use of Various Forms of Hybrid Finance - Coursework Example

The Growth in the Use of Various Forms of Hybrid Finance Introduction The term ‘Hybrid Financing’ signifies a combination of both equity and debt. Therefore, it comprises characteristics of both equity and debt. The hybrid instruments are widely used by the banks and the corporations in the financial sector (Giddy, n.d.). For the investors to enjoy the benefits of both equities and debts, hybrid financing came into existence. As characteristics of debt and equity being completely different, hybrid financing aims to combine the qualities of both the instruments and develop a better option for the investors. The components of the hybrid securities are the face value that is the amount paid to the investor at maturity, interest on the face value is also referred as coupon and maturity date is the date when the security will expire and the principal amount will be repaid or converted into ordinary shares. The other components of the hybrid security are conversion ration, nominal yield and yield to maturity (Pitcher Partners, 2009). Explanation of the Different Forms of Hybrid Finance The different forms of hybrid financing are preference capital/ shares, warrants, options and convertible/exchangeable debentures/bonds, Callable Bonds. Preference Share Capital One of the most popular types of hybrid financing is the preference capital that is a unique type of long term financing. It combines certain features of equity as well as that of debentures. Being a hybrid form it resembles debentures as it has a fixed rate of dividend, doesn’t have any voting rights, ranks higher than the equity as the claimer to the assets and doesn’t have any share in the residual earnings. It also have certain characteristics of the equity capital like dividends are paid after tax profit, payments of preference dividend is not a mandatory payment. The main features of the preference capital are that the capital has an aforementioned claim over the income and the assets of the company. In other words, the payment of the preference capital need to be made in full before the payment of the capital and it must be remembered that during the times of liquidation the whole preference needs to be paid before paying anything to the equity share holders. The preference capital is cumulative by nature which implies that the unpaid dividends are carried forward and are paid before the payment of the ordinary dividends. The life of the preference capital is normally short and there is fixed maturity after which the preference capital has to retire. Convertible Debentures and Bonds The convertible debentures and bonds provide the debentures holders the rights to convert their debentures into equity after a certain period of time. The debenture holders will receive a fixed income till the conversion period and they can even share the benefit that is associated with the equity shares after conversion has taken place. The main advantage of the convertible debentures is that it is a flexible form of financing. The company is able to raise funds from this source at a lower cost as the interest on debentures is deductible. With the conversion option available the companies generally pays a lower interest on this kind of debentures. The shares can be sold at a premium rate. Warrants Warrant is also another type of hybrid financing offered by the financial companies. It is a certificate which permits the holders to buy a stated number of the shares of the company for a stipulated period of time at a stipulated price. They are basically used by the small and the rapid growing business corporations. Warrants are issued along with the bonds that permit the investors to share the company’s growth. A bond that is available along with the warrant has certain characteristics of the equity and also that of the bond. Therefore, it can be said that this kind of securities are hybrid form of securities as it provides the manager an opportunity to expand the securities mix and reach to a broader group of investors. Options Options are instruments through which the holders get an opportunity to sell or purchase specified assets at the price as stated on or before the specified expiration date. The three forms of options are right option, call and put option and warrant option. In case of call option the investor is able to purchase a specified number of shares at a stated or striking price on or before a specified future date. On the other hand, in case of put option the investor gets the option to sell the specified number of shares at a stated striking price on or before a specified future date (Khan, 2004). Callable Bonds It is a bond that can be bought back before its maturity by the issuers. Whenever the bond is called back the premium is paid. It is also called redeemable bond (Investopedia, 2010). It is to be remembered that the callable bonds comprises of ‘double life’ and are more complex and requires greater amount of awareness on the part of the investors. The bond is recalled by the issuer from the investors at the callable date. This implies that the bond is retired by the issuer by returning the investors money (Petroff, 2010). Explain Why and When Companies Should Consider the Use of Hybrids, the Potential Benefits and Risks When considered from the economic point of view, it can be said that the companies can cut the weighted cost of capital if they issue the hybrid form of financing instead of issuing the equity where the cost of capital of equity is more than that of debt. There are certain advantages of issuing the hybrids in comparison to equity as the issuance of the hybrid can help to avoid the dilution of the earnings between the shareholders. There are many concerns for the investors as well as the companies with regards to taxation, rating, accounting, and capital adequacy regulation. The objective of companies in issuing the hybrids is unique. They may desire to treat the securities as equity for two purposes like credit rating purpose and for regulatory capital. On the other hand, the company’s desire to treat the securities as debt for tax purpose, since the corporations might deduct interest that is paid to the debt holder while the dividends are to be paid to the stock holders (Aoyama, 2007). The main benefits of the hybrid financing is that it yields higher income in comparison to the bonds in order to reflect the higher credit risk that is normally associated with these securities. There are tax benefits that can be availed from the franking credits. It provides a share conversion option which is beneficial for the investors as well as the companies. The benefit is that it offers protection during maturity if there is an option for cash back at the rate of issue. There are many cases when the dividends are not paid until and unless the dividends on the hybrids are paid. The potential risk of hybrid financing is that it is very sensitive to the interest rate movements. The prices of the securities may fall because of the downgrading of the credit ratings. It is subjected to the capacity of the issuer or the companies in meeting the financial obligation and the balance sheet fundamentals. There may be positive or negative impact of the share price movement of the ordinary shares. The hybrid financing is basically ranked behind the traditional debt obligation, but it is ranked ahead of the equities (Pitcher Partners, 2009). There is also investment risk in hybrid securities. Both the issuers and the investors have different perceptions from the hybrid securities. From the issuers point of view the reason behind the issuance of the hybrid security is its ability to raise the funds with flexibility in the redemption and the dividends schedule. For the investor the hybrid securities provide a greater selection of the creditable investment choices for the allocation of the portfolio with an aim for improved returns in exchange of higher risk securities. Therefore, the dual benefits provide rise to the conflict of the interest between the investor and the issuer that is more prominent for hybrid financing than for the senior bonds. There is risk because of the external factors such as change in the regulation (Ozeki, 2007). Critically Assess the Role of Hybrid Financing After the Global Financial Crisis In response to the various factors, it has been anticipated that the new kind of investment fund vehicle will play a role in the structured financial sector. It has been known that the hybrid structured fund has been able to issue both the debt and the equity securities having maturity and the redemption profiles which exceed the tenor of the investment assets and therefore eliminating the refinancing risk. It has also been known that the fund may take any form namely limited partnership, unit trust or the limited liability company and it has the flexibility to take the accounting policies matching the investment proposition. Moreover, the investors in the equity funds that is issued by the hybrid structured fund can contribute in any of the residual spare assets of the fund after the claims have been met. The hybrid securities can be utilised for a range of the assets like fixed income investment and alternative assets class. The hybrid structured fund is expected to be suitable for accessing the private equity assets and the opportunities for recovery that are expected to arise after the investment market normalizes. The capital in case of hybrid structured fund may be returned to the investors as a redemption shares or buy back shares. It was expected that after the post financial crisis, the investors will be interested towards the proposal of new investment. The proposals will be structured in a transparent basis where the offer document will disclose all the operating cost as well as the investment risk involved while investing in a particular fund. The offer document for the hybrid structured fund was also expected to be very concise and straightforward after the post financial crisis (Ogier, 2009). It has been noted that until the world recovers from the global financial crisis, it would be prudent to use the hybrid financing and the alternative sources of the funding in order to finance the projects. The worthy projects can be provided with adequate funds in order to make the projects progress smoothly (Barretto & Rezende, 2010). Before the financial crisis, the hybrid instruments were taken as debt rather than equities. After the global financial crisis, there have been changes in the attitude towards the hybrid debt because of the realisation in the market that bonds may not be called and coupons may not be paid. Along with the issuing bank that has relied on the flexibility of the hybrid capital, there has been pressure from the side of the government. The regulators of the hybrid bond-holders shared the possible losses linked with the crisis of the bank. The rating agencies have also re-evaluated the measurement of the risk that is associated with the hybrid debt securities. In the recent past, i.e. rating was set relative to senior rating for the hybrid debt. However, there have been adjustments made in the hybrid rating methodologies to remove the former implied support of the state on such kind of hybrid debt. The hybrid securities were taken as debt instrument and were prices and rated accordingly. There has been increase in the perceived risk of the hybrid debts in the last two years and the securities are traded like equities (Yeats, 2010). Conclusion Hybrid securities are the instruments that contain the characteristics of both equities and debts. There are many types of hybrid securities namely preferred debentures, warrants, convertible bonds and options. There has been a change in the attitude of the issuers, the investors and the regulators because of the experience that they gained in the period of financial global crisis. The hybrid securities once viewed as debt are now viewed as quasi equities that have changed the way these securities are priced, traded and potential risk directed to them. It must be remembered that the hybrid debt is an asset class in its own right and the decision of the investor to allocate the capital to hybrid debt must be taken separately from the decision to invest in senior corporate debt (Yeats, 2010). References Aoyama, H., 2007. Hybrid Securities: A Comparative Study between the U.S. and Japan. Issuers’ And Investors’ Perspectives - Why Do They Issue And Invest In Hybrids? [Online] Available at: http://www.law.harvard.edu/programs/about/pifs/education/sp6.pdf [Accessed December 02, 2010]. Barretto, A. C. & Rezende, E., 2010. Recent Trends in Project Financing in Brazil: What Mechanisms Are Companies Using to Fund Their Projects when Project Finance Is Difficult to Obtain? Executive View. [Online] Available at: http://executiveview.com/knowledge_centre.php?id=11915 [Accessed December 02, 2010]. Giddy, I. H., No Date. Global Financial Markets. Understanding and Using Hybrid Financial Instruments. [Online] Available at: http://giddy.org/dbs/structured/gfmch17.htm [Accessed December 2, 2010]. Investopedia, 2010. Callable Bond. What Does Callable Bond Mean? [Online] Available at: http://www.investopedia.com/terms/c/callablebond.asp [Accessed December 02, 2010]. Khan, M. Y., 2004. Financial Management: Text, Problems and Cases. Tata McGraw-Hill. Ogier, 2009. Hybrid Structured Funds. Emergence of Hybrid Structured Funds. [Online] Available at: http://www.ogier.com/Publication%20Library/Hybrid_Structured_Funds.pdf [Accessed December 02, 2010]. Ozeki, K., 2007. Hybrid Securities, a New Investment Choice. Investment Risk for Hybrid Securities. [Online] Available at: http://media.pimco-global.com/pdfs/pdf_sg/PER038_122606_hybrid_secs_SGP.pdf?WT.cg_n=PIMCO-SINGAPORE&WT.ti=PER038_122606_hybrid_secs_SGP.pdf [Accessed December 02, 2010]. Petroff, E., 2010. Callable Bonds: Leading a Double Life. Investopedia. [Online] Available at: http://www.investopedia.com/articles/bonds/07/callable_bonds.asp [Accessed December 02, 2010]. Pitcher Partners, 2009. Hybrid Securities. Benefits And Risks Associated With Debt Instruments. [Online] Available at: http://www.pitcher.com.au/Uploads/Hybrid%20Securities%20March%202009.pdf [Accessed December 02, 2010]. Yeats, S., 2010. The Past, Present and Future of Hybrid Debt. State Street Global Advisor. [Online] Available at: http://www.ssga.com/library/exchng/Past_Present_and_Future_of_Hybrid_Debt_Stephen_Yeats_2.26.10CCRI1267711779.pdf [Accessed December 02, 2010]. Read More