Factiva

Wall Street is drooling over what looks like a free lunch. The latest types of hybrid securities, which combine characteristics of shares and bonds but are more cost-effective, are finding an eager audience among companies in the US and Europe.

Rating agencies like hybrids because they have loss-absorbing features usually associated with equity. And in regulated industries such as banking, watchdogs have accepted them as core, equity-like capital as well.

But the products are complicated and labour-intensive to put together, meaning investment banks can charge a premium fee - perhaps double or more what they would charge for a regular bond issue. Together with the prospect of heavy issuance, that has got Wall Street excited.

Both retail and institutional investors have snapped up recent issues. Last month, a huge Dollars 2.5bn sale of Wachovia Income Trust Securities, or Wits, by the fourth-largest US bank attracted demand of nearly Dollars 10bn.

"We're in one of those temporary nirvanas where issuers and investors both seem very happy," said Erin Callan, head of global finance solutions at Lehman Brothers.

Securities that straddle the debt and equity worlds are not new. They combine features of debt such as regular interest-like payments and equity-like characteristics such as long or perpetual maturities and the ability to defer payments.

Preferred stock, a type of senior equity that receives a set dividend before common shareholders get anything, has been around for a long time.

About a decade ago, regulated financial institutions started issuing so-called trust preferred securities, or Trups, which are functionally similar to preferred stock but can be structured to achieve extra benefits such as tax deductibility for the issuing company. Other hybrid structures have also been tried.

But bankers were still searching for what several called the "holy grail" - an instrument that looked like debt to its issuer, the tax man and investors, but like equity to credit rating agencies and regulators.

That goal came closer a year ago when Moody's, the credit rating agency, changed its previously conservative policies, opening the door for it to treat structures with some debt-like features more like equity.

That meant that on top of other benefits, companies could issue hybrid products - which cost them only slightly more than regular debt - to replace costly and less flexible share capital without denting their credit ratings much.

"It was absolutely Moody's that started the ball rolling," said Kevin Conery, preferred strategist at Merrill Lynch. Standard & Poor's and Fitch Ratings also clarified their thinking on hybrids, and the three agencies are now broadly aligned.

Results came first in Europe, thanks to tax regimes that made it easier than in the US to develop new products that both improved rating treatment and qualified as debt for tax purposes. A Euros 1bn (Dollars 1.2bn) issue for Vattenfall, the Nordic energy company, was "a watershed", according to John Dickey, global head of new products at Citigroup.

The hybrid secured "basket D" treatment from Moody's, meaning 75 per cent of the issue was categorised as equity rather than debt for rating purposes. A clutch of other issues followed in Europe, with the US not far behind.

"Hybrids have become incredibly effective corporate finance tools," said Mr Dickey. He and other bankers say the instruments can be attractive to issuers even if circumstances prevent them being tax deductible, because the cost of capital advantage over a blend of traditional debt and equity is so great.

If a company wants to raise Dollars 100m of capital with half of it qualifying as equity for rating or regulatory purposes, there are, simply put, two options: Dollars 50m each of traditional debt and stock, or Dollars 100m of hybrid capital. In some cases, the marginal cost of funding using traditional sources could be almost twice as high as with hybrid capital in today's market (see example).

The advantage could be bigger still with 75 per cent equity treatment

Last August, Lehman Brothers was among the first to test the US market for the new class of hybrids when it issued Dollars 300m of securities on its own behalf, calling them Enhanced Capital Advantaged Preferred Securities, or Ecaps.

"That was a clever balancing of Moody's view on hybrids, regulatory views on hybrids and tax treatment in the US," said Barbara Havlicek, who chairs Moody's hybrid analysis committee. Several variants of the structure have since been tried in the US, with both financial institutions and industrials making the most of investor demand.

Financial institutions, for example, are highly sensitive to their capital position vis-a-vis regulators.

"We have to satisfy our regulator's needs as well as getting higher rating treatment," said Daryl Bible, treasurer of US Bancorp, which issued Dollars 375m of hybrid securities in December. Blessed by the Federal Reserve as a component of tier one capital, the new hybrids "give us flexibility to issue equity-like securities more easily than issuing common equity," Mr Bible said.

He anticipates issuing further hybrid capital in 2006, partly to replace higher cost instruments already in place and partly to help the company grow. If it wishes, USB is allowed to call, or repay, Dollars 1.8bn of more costly capital this year alone.

Among all US banks, up to Dollars 35bn of Trups issued five or 10 years ago are callable this year, according to bankers. Many expect the bulk of that capital to be replaced by new hybrid instruments. Insurance companies are also potentially well-suited to issuing the new forms of hybrid.

All that potential new business, and the high fees available, has investment bankers racing to lock in clients for their particular versions of the structure. Citigroup, Goldman Sachs, Lehman and Merrill were among the banks that pioneered the structures, with rivals including Deutsche Bank and JPMorgan close behind and others chasing hard.

Many bankers also see plenty of potential for non-financial companies to benefit from the new hybrids. In Europe non-financial issuers including Henkel, the German consumer goods maker, have tapped the market.

"This could be an interesting product in the context of funding acquisitions â * to maintain ratings," said James Esposito, head of investment grade syndicate at Goldman. That was the rationale for the first non-financial new hybrid issue in the US - a Dollars 450m deal for Connecticut toolmaker Stanley Works, a structure dubbed an Etrups, or Enhanced Trust Preferred Security.

Mr Dickey of Citigroup added: "It is compelling for issuers looking to finance acquisitions, repurchase shares, fund pensions or lower their overall cost of capital in a ratings friendly manner."

Funding a share buy-back was part of the aim of a Dollars 500m issue by Burlington Northern Santa Fe, a US railway company.

If new hybrids do take off this year, they could bring Wall Street a bonanza, with some estimates of issuance this year running as high as Dollars 40bn, about 10 times last year's total.

"I don't think we're going to end up saying the reality fell short of the hype," said Chris Whitman, head of debt capital markets for Deutsche in the US.

One potential damper would be a change of heart by a rating agency, by regulators, or by the tax authorities. The first looks unlikely, with the three big rating agencies now roughly in line in their treatment of hybrids. The Fed, meanwhile, has accepted equity treatment for hybrids based on its own analysis, which is consistent with new Basel II guidelines, according to Mr Bible at US Bancorp.

As for the tax authorities, hybrids are not considered a grey area. "The tax law is very clear," said David Miller, a tax partner at Cadwalader, Wickersham and Taft. "So long as an issuer satisfies (specific requirements), the issuer will be entitled to interest deductions."

The only reservations about the new hybrids appear to be held by investors. Even in that constituency, however, many appear persuaded. "I would put us in the excited camp," said Bernard Sussman, chief investment officer of Spectrum Asset Management, a fund manager specialising in the preferred market.

Deals have been priced with between half and one percentage point more return than senior debt of the same companies, he said. "In our estimation, that's sufficient compensation. They have been pretty strong credits - they are risks worth taking."

He conceded that investors' search for extra yield, a feature of all types of investment in the current market environment, may have caused some people to consider hybrid investments without doing enough homework. "What's key is that the investor truly understands the structure," he said.

Tom Houghton, a corporate bond fund manager at Advantus Capital Management, is less convinced. Many investors, he said, understandably prefer to buy riskier securities of companies they like rather than look elsewhere - but some may be sticking their necks out with the latest hybrids.

"I think investors have to be careful, and understand these are more equity-like than debt-like," he said. "We have not bought any. We still have a healthy amount of scepticism."

Moody's, the rating agency that triggered this wave of activity, also sounds a note of caution.

"The thing that is yet to be seen is how these things perform in a weakening credit environment," said Ms Havlicek. "Whether or not compensation is adequate is a question that will prove out over time."

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