What’s a hybrid bond?

What exactly is a “hybrid bond?”

Bonds classified as “hybrid” are a mixture of debt and equity. Whereas the hybrid starts out with a fixed interest rate, this interest rate may change over the very long or unlimited tenors of the bonds, in line with the bond conditions. Interest payments can be suspended if no dividends are paid and no shares are bought back. In addition, in the event of an insolvency, the bonds shall be serviced only after all other obligations have been met and only before the shareholders. This resembles the treatment of equity and shares.

Is the hybrid bond a junior security? And if so, what does that mean?

Hybrid bonds are junior or subordinated securities In the event of an insolvency or liquidation, hybrid bonds are only serviced once the company has fulfilled all other obligations (including senior bonds) it holds towards to third parties. Hybrid bonds are therefore only superior over shares.

How does a hybrid bond differ from a regular bond?

Hybrid bonds’ main discerning feature is that they have very long or unlimited tenors. They can be cancelled and repaid prior to maturity only by the company. The precise modalities are established in the bond conditions. Interest payments can be suspended if no dividends are paid and no shares are bought back. In addition, hybrid bonds are subordinated, which means that in the event of an insolvency or liquidation, they are serviced only after all other obligations (including those related to RWE senior bonds) have been met. Therefore, as hybrid bond purchasers do not exactly know at which point in time they will retrieve their original hybrid bond investment and as they are exposed to a lower priority than that of regular bonds in case of insolvency, the interest rates on hybrid bonds are much higher than that of a senior bond.

What risks are investors confronted with when subscribing hybrid bonds as opposed to regular bonds?

The major risks are:

  1. the undefined tenor;
  2. the “subordinated” treatment: In the event of the company’s insolvency or liquidation, hybrid bondholders are only treated preferential over shareholders. All other receivables are treated superiorly;
  3. the suspension of interest payments: Under certain conditions, interest payments may be suspended, e.g. in cases where no dividends are paid. However, accrued interest must be paid retrospectively once dividend payments are resumed or the hybrid bond is repaid.

Why is the return on a hybrid bond higher than on a senior bond?

Because it bears a higher risk—in terms of its tenor, interest payment and the treatment of the creditor/buyer in the event of the issuer’s insolvency.

Please understand that this information cannot replace a comprehensive risk consulting session, e.g. with your financial advisor.