Hybrids are able to achieve this balancing act because rating agencies award a certain amount of "equity credit" for each issue, meaning that part of the capital raised by the issue–typically 50% or 75%–is treated as equity. To pull this off, the capital has to incorporate a range of equity-like features such as subordination, deferred coupons and ultra-long maturities. In other words, the issuer has to make its debt more equity-like. The investor, meanwhile, gets a higher yield, but gives up first place in the queue if the issuer defaults. The end result is that the issuer is able to borrow money without making the kind of commitments involved in a normal bond–and the rating agencies smile on this.
A company could achieve the same thing by issuing both stock and debt, but hybrids do the job more cheaply, says Adriaan Van der Knaap, managing director in the financial institutions group (FIG) at UBS in New York and co-head of the FIG's debt capital markets and FIG solutions teams. He gives the example of a company which needs to raise $1 billion to finance an acquisition using 50% equity and 50% debt. Its cost of capital is 15% for the equity and 5% for the debt, giving it a 10% compound cost of financing. "A $1 billion hybrid with equity credit of 50% would achieve exactly the same, while costing as little as 7%, even before taking into account the tax-deductibility of the coupon–so you can see the benefit," he says.

Of course, that makes hybrids sound incredibly simple. Yet, the evolution of this market has been anything but straightforward. The most recent watershed event took place last September, when the National Association of Insurance Commissioners (NAIC) reversed an earlier decision that had classified hybrids as equities, meaning that insurers would need to hold more capital against those investments. With insurers typically reckoned to make up around 25% of the buyers for hybrid securities, the NAIC's stance seemed to remove a huge chunk of demand and liquidity from the market. "The NAIC stance was a focus of the market in 2006," says Chase's Chessin. "We saw a pause in hybrid issuance, coupled with spread widening and increased cautiousness. But since the new resolution was adopted in September, we've seen new issue volume pick up, spreads tighten significantly and structural premiums decline." Chase's in-house hybrids index, which tracks spreads on a basket of hybrid issues, has tightened by around 65 basis points since July, she says.

This background of uncertainty had helped keep investors on the sidelines, bankers say, limiting the amount of money that issuers were able to raise. In the U.S., the biggest single issue has been Southern Union Co.'s $600 million bond in October. Europe, by contrast, has seen several corporate issues in excess of $1 billion, with one issue by Siemens in September topping $2 billion.

With rating agency methodologies maturing and insurers back in the market, bankers believe that the U.S. market is also ready for takeoff: "As the year has progressed, the people who buy senior debt have increasingly been buying hybrids because they believe [they're] going to be more of a component in the supply of new issues," says Deutsche's Curran. "So when more traditional corporates come to market, I think they will be very well-received."