Why Do Firms Issue Hybrid Bonds?

This study examines why firms issue hybrid bonds. Hybrid bonds can be structured so that they can be classified as either debt or equity under International Financial Reporting Standards (IFRS) and/or by credit rating agencies. We exploit this setting to examine whether firms consider leverage based on IFRS and/or credit ratings when structuring hybrid bonds. We find the following: First, unrated firms issue hybrid bonds that are classified as equity under IFRS if their IFRS-based leverage is higher. Rated firms issue hybrid bonds classified as equity by credit rating agencies if their credit rating is at risk and when their credit rating deteriorates. Second, drawing on the debt contracting value of accounting information and credit ratings, we expect and find that rated firms with stronger credit ratings issue hybrid bonds structured to be classified as equity solely by credit rating agencies but as debt under IFRS. Conversely, rated firms with a weaker credit rating and a higher default risk issue hybrid bonds that are classified as equity under IFRS and by credit rating agencies. Firms incur considerable interest costs when issuing hybrid bonds, suggesting that firms associate substantial benefits with an equity classification under IFRS and/or by credit rating agencies.