Study on the Uses of Hybrid Finance Finance Essay

An instrument of hybrid finance can be defined as a security which holds the combination of features of both equity and debt. Users can benefit from the positive factors of equities and debt instruments without incurring the disadvantages of them. However there are also risks that are associated with the use of hybrids.

There are various forms that hybrid financing can take, for example convertible bonds, warrants, preference shares, callable bonds and innovative hybrids. In this essay the various forms of hybrid finances are reviewed with reference to why companies use them. Details about the advantages and disadvantages of using each of the various instruments will then be given. This will follow with a section on why companies would and would not want to obtain a hybrid finance structure, and will then go on to talk about how the use of hybrid finance has changed during the current climate and the reasons behind this. Finally the conclusion will summarize the contents of this essay. A convertible bond is a bond which can be converted into a fixed amount of the firm’s equity at a specific time and price throughout its life. This is done at the discretion of the bondholder.

This hybrid finance instrument is generally issued because as a result of it, there is a delayed dilution of earnings per share and common stock. Furthermore, the bond is obtainable at a lower coupon rate than with that of a straight bond.

Convertible bonds let the firm play down negative understandings that investors may have of its corporate actions. Investors consider this as a value-added element. Convertible bonds combine the advantages of bonds and stocks. It presents a lower rate of return in return for the option to trade the bond into stock. Investors are able to benefit from the interest payments and any stock increases.

However, rises in interest rates result in a decline in the stock price. If stock prices fall, the price of the convertible bond would also fall. Another disadvantage is that most convertible bonds have a callable character, which as a result investors have to reinvest the earnings in an investment where monetary gains are less. Convertible bonds should be converted when the stock price reaches a particular level. This is often very high and as a consequence it is advised, instead of waiting for the level to be reached, the stock should be purchased at the current lower price. A warrant is a quoted certificate which is transferable. The holder of a warrant has the right but not an obligation to buy or sell an underlying security at a particular price, quantity and future time.

The particular price is called a strike price. In this manner it is comparable to an option. However, the company issues it rather than being an instrument of the stock exchange. The warrant represents a security which is distributed by the issuing company as opposed to an investor holding the shares. The advantage of using warrants is that companies can use them to lure investors into buying the new security.

This is because in general warrants have low costs and the initial investment that is needed to gain a large amount of equity is reasonably low. Throughout a bull market, warrants offer significant gains to an investor and during a bear market they can present protection to an investor. Warrants can also be used to raise a shareholder’s confidence in a stock, given that the underlying value of the security essentially does increase over time. Furthermore, warrants have high transparency and are therefore attractive for speculators and hedgers. Another advantage of the price of warrants being low is that the leverage and gearing they present is high.

Thus there is more of likelihood for larger capital gains. On the other hand, this could be seen as being disadvantageous because it could lead to larger capital losses. Warrants do not offer the holder any shareholding, voting or dividend rights.

Thus they have no say in the operations of the company, even though they are affected by any decisions that are made. As well as this, there is also the risk to the investor because the certificate value could drop to zero before the warrant is exercised. This would result in the warrant losing all redemption value. A preference share is legally a share, but it is different from an ordinary share. Preference shares can also be known as preferred stock. The shareholders do not carry voting rights.

They have the economic effect comparable to that of bonds. Holders of preference shares have the right and obligation to be rewarded the dividend before the ordinary shareholders. The dividends are fixed like bond coupons but there are usually times when payments are delayed or not paid. Preference shareholders have a lower priority than debt holders if a company is liquidated, however they have a higher priority than ordinary shareholders. These factors let the cash inflow for preference shares to be more like that of debt, as opposed to that of ordinary shares.

Fixed dividends are similar to interest payments; however because they are legally shares, they receive the same tax treatment as shares. On the other hand preference shares also have characteristics of equity, for example there is an opportunity for appreciation to occur, even though this would be reduced compared to that of ordinary shareholders. A callable bond is a bond that can be traded in by the issuer before its maturity. When it is issued, details about its redemption and price need to be explained. A premium is normally paid to bond holders when the bond is called and the earlier the bond is called, the higher the premium. The bond is usually called because of a decline in interest rates. If the interest rate has seen a decline since the company first issued the bonds, the company will wish to refinance this debt at a lower rate of interest and will therefore call its existing bonds and reissue them at a lower rate of interest. This is because it saves money on paying coupon payments. A disadvantage to the bondholder is that they have no other option in the matter if the bond is called.

Interest payments stop soon after the bond is called. Thus there is no reason to hold on to it. In general, callable bonds carry a call protection, which means that they cannot be called for a certain period of time. This can be a disadvantage for the issuer. Innovative hybrid financing is a type of debt security which is combined with derivatives. It is a well-liked method of hybrid financing. The income for innovative hybrid financing is linked with numerous economic variable quantities. These include foreign exchange rate, interest rate, commodity price, share market index and several others.

Innovative hybrid financing is used to assist in handling risk. There are numerous benefits and reasons why a company would use hybrid finance. Firstly, capital can be increased while avoiding diluting existing equity excessively.

Hybrid financing gives investors a wider variety of return and risk. It also has a selection of tax treatment combinations, thus allowing investors to benefit from these and other regulatory benefits they offer. Luder (2005) and Shaviro (2009) suggests that investors can benefit from the tax treatment by choosing whether they are taxed at their own marginal tax rate or at the corporate tax rate, depending on whether they treat the financing characteristics as debt or equity. It can also be used to decrease control risk for either the issuer or the borrower. Hybrid financing plays a significant role in making the market more comprehensive. When a company chooses to use hybrid financing, the main reasons behind it is because the company can keep equity ownership and voting rights, at the same time as being able to raise capital for future needs.

Using hybrid financing lets this happen, for example exercising warrants brings in new equity capital while avoiding the need to give up low coupon debt. As for convertible bonds, no new funds are brought in, but the debt ratio is lowered when the bonds are converted, thus allowing new debt to be issued. When issuing hybrid finance, the company has to realise that they could have debt outstanding for a number of years before it can be exercised, if stock prices do not rise over time. On the other hand, the reasons why companies may not want to issue hybrid finances are because hybrid securities are very responsive to interest rate movements and security prices may decrease because of a credit rating downgrade. Although hybrid financing is more favourable than equity, it ranks behind debt obligations. Another downfall is that a movement in the price of ordinary shares can have a negative impact. Hybrid financing depends on the issuer’s ability to meet its financial requirements and other balance sheet essentials. In recent years, there has been a movement in the pattern of how companies use hybrid financing.

Hybrid financing started off being very popular within companies. This is because regulators and issues had taken on more sophisticated approaches to controlling risk. Beales and Wighton (2006) reported that companies around the world would want to use this form of financing because of various benefits they would receive. However, in the current economic climate a change could be seen.

Some companies and investors were not benefiting from the use of hybrid finance and therefore there was a decrease in the issuance of hybrid finance. For example in 2008, due to a combination of factors, Crédit Agricole reported the market for convertible bonds was shut down for a few months. These factors included the widening of credit spreads, a decline in the equities market and a drop in hedge funds’ leverage. Aiginger (2009) suggests that a contributing factor to the financial crisis was the lack of judgment in risk management. This can be linked to why hybrid financing was not beneficial to companies and investors. If companies had been prudent, they would have been more cautious as to which hybrid securities they adopted.

Investors became more cautious as to how they invested their money; their confidence in companies was reduced significantly as they saw companies becoming bankrupt. The financial crisis has lead to a decrease in the use hybrid securities not just in the United Kingdom, but all over the world. As the conditions of the current climate improve, there has been proof of the use of hybrid financing increasing and there is talk that it will continue to increase.

Erste (2010) suggests that the reason behind why hybrid financing is becoming popular again is because of the low interest rate environment. ‘I am optimistic that we will evolve into a situation in which there are more hybrid securities of one form or another.’ Steven Sahara (2010). This evidence given by the global head of hybrid capital structuring at Calyon, supports the idea that there will be an increase in the use of hybrid financing in the future. Kalkavan (2010) comments on how investors are pleased that the °stanbul Stock Exchange (°MKB) are introducing warrants. It is suggested that the introduction of warrant shows promises for a much deeper market and has attracted investors because of the limited risk feature. In conclusion, I believe that hybrid financing can be beneficial to companies as it can help when investors have the belief and are afraid that funds will be invested in a way that will increase the firm’s risk profile. Compared to using straight debt, hybrid financing can reduce this fear for investors. However the financial crisis has shown that companies need to be cautious as to the types of hybrid finance that are issued. On a more positive note, it can be seen that as the situation improves, more companies are adopting different forms of hybrid finance.

This is attracting investors as the rate of risk is reducing.

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