Chapter 24
INVESTORS AND MARKETS : Hybrid securities

Hybrid securities often seem to be equity, but that is not always the case. A convertible bond that is not converted remains a debt; a bond with attached warrants is, likewise, still a debt.

Many of these hybrids give the impression of lowering the company's cost of financing. Do not believe it! In markets in equilibrium, all sources of financing have the same cost when adjusted for the risk taken by the investor. It is not enough to look only at the apparent cost; the full cost of any source of financing must be understood and taken into account. Similarly, these securities give the impression of belonging to the world of high finance. More often than not, though, their use is a sign that the issuer is in trouble or is having difficulty placing ordinary equity or debt securities with investors.

Agency theory explains the existence of these products by showing their usefulness in resolving potential conflicts between shareholders and creditors or between shareholder-managers and outside shareholders. Signalling theory sees in them the mark of an undervalued, heavily indebted company that is unwilling to finance itself through a traditional capital increase.

A convertible bond is like a traditional bond, generally one bearing a fixed rate, except that it also gives the holder the right to exchange it for one or more shares (depending on the conversion ratio) of the issuing company during a conversion period set in advance. Its value is analysed as the sum of the value of the traditional bond and the value of a call option on the shares with an exercise price equal to the conversion price.

Convertible bonds are issued at lower coupon rates than traditional bonds. This is not an advantage for the issuing company but merely the compensation for the call option it has granted the investor “at no charge”.

A subscription warrant is a security that allows the holder to subscribe during a given period, in a proportion and at a price fixed in advance, to another security. A subscription warrant may be attached to an issue of shares or bonds or distributed by itself “at no charge”. Conceptually, a warrant is a form of call option sold by the company on shares to be issued. Issuing warrants enables a company to accomplish a capital increase by a process of gradual dilution.

Preference shares, mandatory convertibles, deeply subordinated debt and exchangeable bonds are other categories of hybrid securities.