November 20, 20121

Capital Market Opinion

Equity Capital Classification for Hybrids and

Recommendations for Improvements

Recently, there have been heated debates over whether hybrids issued by Doosan Infracore

can be counted as equity capital in the company’s balance sheets. Hybrids are bonds that

combine the characteristics of equity and debt, and companies issue them to replenish their

capital base. Recently, the Commercial Act was revised and regulations over corporate bond

Kim, Pil-Kyu＊

All opinions expressed in this paper represent the author’s personal views and thus should not be interpreted as Korea Capital Market Institute’s official position.

Ph.D., Senior Research Fellow, Research Coordination Department, Tel: 82-2-3771-0631, E-mail: pkkim@kcmi.re.kr

Hybrid bonds are securities that have characteristics of both equity

and debt. They are primarily issued by banks that want to accumulate

more equity capital. But due to recent changes, such as the revision of the

Commercial Act and the introduction of IFRS, non-financial firms can also

issue hybrid bonds to improve capital adequacy. Accordingly, methods for

classifying hybrid bonds in balance sheets are receiving wide attention.

The most important thing is whether hybrid bonds issued by non-financial

firms satisfy the basic conditions of equity capital as stipulated in IFRS.

According to IFRS, only a perpetual, subordinated bond that is unlikely to be

redeemed before expiration can be classified into equity capital, as opposed

to liabilities, in balance sheets. This, above all, should be considered most

importantly to determine whether a hybrid bond qualifies as equity capital.

Especially, a step-up clause will likely cause early redemptions, so clear

standards should be formed in this area.

Hybrid bonds will help Korean firms improve their financial structure only if

they are issued as equity capital under clear market standards.

2

Capital Market Opinion

issues were relaxed. Also, the International Financial Reporting Standards (IFRS) allows hybrids

with certain conditions to be classified as equity capital. Against the backdrop, more non-

financial firms are pushing for hybrid securities. In September 2012, Doosan Infracore Co.

issued a $500 million bank-guaranteed hybrid in overseas markets. But controversy was raised

over whether it should be categorized as equity or debt in balance sheets. The result of the

controversy will impact future hybrid issues by Korean firms.

This article first explores the characteristics of hybrid bonds and the requirements to appear

as equity capital in balance sheets. Then, it reviews whether Doosan Infracore’s recent issue

meets the requirements. Last, the article discusses things to consider for future hybrid issues.

What is a hybrid bond, and how is it characterized?

A hybrid is a security that holds the characteristics of both debt and equity. It is considered

a bond because it pays out a coupon regularly. But it is also a type of equity capital because it

doesn’t have a maturity date in the traditional sense. Generally, a hybrid has a 30-year maturity,

with options for maturity extension, and early redemption (call option).

Since the Korea Exchange Bank first issued a hybrid in May 2003, banks in Korea have issued

hybrid bonds several times to improve their capital positions. In the post-crisis era especially,

Korean banks issued hybrid bonds, which were purchased by the government-supported bank

recapitalization fund.

Notable issues for non-financial firms are PT Cheil Jedang Indonesia’s KRW 200 billion hybrid

in April 2012, followed by Doosan Infracore’s bank-guaranteed $500 million hybrid in overseas

markets.

Non-financial firms can issue hybrids because the revised Commercial Act relaxed regulations

over corporate bond issues. The revision allows diverse corporate bonds to be issued and scraps

the limit on issues. These revisions are the main drivers for the wider use of hybrid bonds.

Another reason is the changes in accounting standards: Under IFRS, hybrid securities are

treated differently. In the past, a security’s legal format determined whether it was equity or

debt. But IFRS uses a security’s actual cash flows and financial value, and views hybrid bonds as

equity capital in the sense that the issuer can delay interest and principal payments.

Accordingly, non-financial firms also can utilize hybrid bonds to replenish their capital. There

are other benefits as well: Hybrids allow companies to secure capital that won’t affect their

November 20, 20123

Capital Market Opinion

managerial power, and coupon payments for hybrids are included in deductible expenses in

accounting, which leads to tax savings.

Hybrids and the conditions for equity capital classification

A hybrid bond can be regarded as equity capital for three reasons: It ranks after other debt,

its maturity is extendable, and coupon payments can be delayed.

First, since it ranks after other types of debt, it’s basically in the middle between equity and

debt. But it actually ranks after all liabilities except for ordinary shares. Hence, it’s viewed as

equity capital.

Second, like perpetual bonds, it pays out a coupon without principal payment. In general, it

does have 30-year maturity, but the issuer can use the option attached to the issue and extend

the maturity. This is why this type of security is considered similar to equity capital. Third, a

hybrid issuer can delay or sometimes cancel coupon payments.

Those three traits significantly impact how a hybrid is treated in balance sheets. It’s safe to say

that such a security has a financial value like equity capital if the security’s maturity is permanent

or extendable, if the issuer can delay coupon payments, and if it ranks after all other debt.

But some hybrids are sold under terms that make them less like equity capital. A case in point

is the call option. Assume that a hybrid comes with a call option that will be effective some

time after the issuance. A call option gives the issuer the right to pay back its debt earlier than

the expiration date. But in practice, most investors in hybrids expect to receive their principal

on the exercise date. Hence, investor confidence is seriously undermined if the call option is

not exercised. This is exactly what happened when Woori Bank didn’t exercise its call option on

subordinated bonds in 2009 and caused the CDS price to skyrocket.

Another example is a step-up clause that promises to increase a hybrid’s interest payment

when the call option is first exercised. The larger the increase in interest payments in a step-up,

the heavier the burden for interest payments. Then, the issuer is likely to redeem the security

before expiration. This will also undermine a hybrid’s equity-like feature.

Last, possible delays on coupon payments also affect whether a hybrid is counted as equity

capital. A hybrid without the delay clause is hardly regarded as equity capital. Although hybrids

have a delay clause, whether they’re equity or debt depends on what happens to the delayed

interest payment. For instance, a hybrid with a cumulative interest payment may be classified

differently than a non-cumulative hybrid.

4

Capital Market Opinion

Doosan Infracore’s hybrid

Doosan Infracore issued 30-year hybrid bonds whose maturity can be extended. The

call option attached will be effective five years after the issuance. The hybrid also has credit

enhancement, in which a special purpose company (SPC) jointly established by a few Korean

banks guarantees to repay the debt if the call option is not exercised. Moreover, it has a step-up

clause that will increase interest payment significantly in five years and again in seven years if the

bonds are not redeemed.

There are a few reasons why this hybrid doesn’t appear as equity capital. First, it’s not a

subordinated bond. If the call option is not exercised, the SPC, not Doosan Infracore, is obligated

to repay the debt. But still, without a subordination clause, it is debt rather than equity.

Second, it has a step-up clause. The issuer must increase interest by 500 bps in five years and

by 200 bps in seven years if it’s not redeemed. This means that the burden for interest payment

will rise significantly. If it’s likely that the issuer can’t stand the burden and wants to repay the

debt in five years, it shouldn’t be regarded as perpetual bonds.

Accounting standard for hybrids

The controversy over Doosan Infracore’s hybrid came about because the concept of capital

varies in Korea’s accounting, regulatory, and legal standards, and the discrepancy makes it tricky

to devise the Korean IFRS (K-IFRS). Under the accounting standard, Doosan Infracore’s hybrid is

equity capital. But a controversy may arise over whether the hybrid’s actual financial value has

equity-like aspects. Such discrepancy should be thoroughly reviewed before setting clear K-IFRS

standards about hybrids.

Especially, as for hybrids issued by non-financial firms, regulators should refer to the Basel

guidelines, which in general stipulate that only subordinated, perpetual hybrids with limited

step-ups appear as equity capital in balance sheets as long as they not redeemable within five

years after issuance. But in the aftermath of the global financial crisis, Basel III strengthened the

guidelines: Hybrids with limited step-ups are no longer regarded as equity capital under Basel III.

Now, all hybrids with any step-up clause, regardless of the level of interest increases, tend to be

classified as debt.

Of course, additional review should be conducted about whether different standards should

be applied to non-financial issuers and banks issuers: Banks are subject to tougher regulations,

November 20, 20125

Capital Market Opinion

and the regulatory standard is used for their capital. But whether a hybrid itself carries equity-like

characteristics is more important than industry-specific considerations. If any market practice

or specific clause attached to a hybrid undermines the perpetuity of the hybrid, it shouldn’t be

considered equity capital.

In addition, it is necessary to build realistic and clear standards to assess whether a hybrid’s

subordinated, perpetual, and non-redeemable structure imposes any burden on its issuer.

Hybrid bonds will help Korean firms improve their financial structure only if they are recognized

as equity capital under clear, predictable standards.

Korean firms need to shore up their capital base through long-term vehicles, and hence they

should push for issuing hybrids with clauses that meet the traits of equity capital. Surely, the

recently issued hybrid bonds have a merit because they help issuers raise short-term capital on

favorable terms. But in the long term, the early redemption clause may only impose a burden on

the issuer’s financial structure.