There's a lot of talk these days on Wall Street about hybrids.

No, not fuel-efficient hybrid cars, but hybrid securities -- financial instruments that combine the best characteristics of stocks and bonds.

This year, Wall Street is expecting a flood of hybrid offerings from U.S. companies, especially banks looking to refinance older, more costly debt. By some estimates, U.S. banks could sell up to $40 billion in hybrid securities in 2006, a more than fivefold increase over last year.

Many expect other U.S. companies also to begin eyeing hybrids, but some worry that widespread use of the securities outside of the financial sector could spell danger for investors.

To be sure, hybrid securities are not new. Any corporate bond that converts into stock is technically a hybrid security.

But recent moves by regulators and credit rating agencies are making a new line of hybrids particularly attractive to banks looking for a cheaper way to finance stock buybacks and acquisitions.

This new breed of hybrids, called "perpetual trust preferred securities,'' enables financial institutions to raise cash without impairing their credit ratings. That's because such offerings are treated by the rating agencies as equity -- even though they look a lot like bonds. In addition, the Federal Reserve recently determined that these new hybrid offerings can be used by banks to bulk up their Tier 1 regulatory capital.

Tier 1 capital, sometimes referred to as core capital in the banking world, is a figure regulators keep a close eye because it's a measure of lender's ability to handle unforeseen losses.

Already, Wachovia ( WB) and Washington Mutual ( WM) have cashed in on the hoopla surrounding this new line of hybrids, selling so far this year a combined $4.5 billion in securities to investors seeking higher-yielding investments.

One of WaMu's hybrid offerings, for instance, yields a rich 7.25%, well above the current 4.5% payout on a 10-year Treasury note. With yields like that, it's no surprise there are plenty of hedge funds, mutual funds and pension plans eyeing bank-issued perpetual trust preferred hybrids.

"These so-called perpetuals are the flavor of the month for financial institutions,'' says Ellen Lapson, a managing director for Fitch Ratings.

In many respects, a perpetual trust preferred security is not much different from a "trust preferred security,'' an older model of hybrid favored by banks and insurers in years past. In both cases, a bank establishes a trust that issues long-term bonds that makes fixed- or variable-interest payments. The bank that issues either of these hybrid securities gets to claim a tax deduction on the interest payments.

The big difference between these two securities is that a perpetual hybrid has no maturity date on the bonds it issues. Traditional trust preferred securities normally mature at some predetermined date.

The elimination of the maturity date on the bonds was a significant one because it persuaded Moody's Investors Services last year to join with other credit rating agencies and begin treating perpetual offerings as a sale of stock rather than a sale of debt. This ratings shift by Moody's had big ramifications for the hybrid market because it meant a company now could sell hybrid securities without taking any hit to its credit rating.

For obvious reasons, a company's credit rating is imperiled when it takes on more debt. And before perpetual hybrids came into vogue, the rating agencies had treated trust preferred hybrid offerings as newly issued debt added to a bank's balance sheet.

The removal of the maturity date solved that problem, but raised another one. Many investors who buy into hybrid offerings don't want to be left holding their bonds forever. They want eventually to be taken out of the deal, especially since hybrid owners rank low on the list of who gets paid back if a company becomes insolvent. So, to make perpetual hybrids more enticing to investors, these deals also include a provision saying the bank that issues the bonds will buy them back in either five or 10 years.

On Wall Street, hybrids are being pitched as a win-win situation for everyone involved.

Banks benefit from a cheaper way to raise capital. Investors win because they get to buy high-yielding securities. Meanwhile, Goldman Sachs ( GS), Merrill Lynch ( MER) and Lehman Brothers ( LEH), the Wall Street firms peddling these hybrids, win as they get another opportunity to rake in investment banking fees.

"All of the stars are aligned for hybrids,'' says David Hendler, a financial analyst with CreditSights, who anticipates $46 billion in hybrid deals by U.S. banks this year.

Hendler also predicts that banks could use perpetual hybrids to refinance $53 billion in older trust preferred securities that have maturity dates coming due over the next two years.

But some say it's too soon to declare this new breed of hybrid road-tested.

Even as he predicts a surge in bank-issued hybrids, Hendler says there's concern about just how big an appetite the market will have for these deals. That's especially the case if too many hit the market at one time.

A bigger concern is other companies start following the banking industry's lead in doing hybrid deals, as is the case in Europe. While few doubt most banks are financially sound enough to live up to their commitments, some worry what will happen if financially strapped companies start issuing hybrids.

The decision by credit rating agencies to begin treating perpetual hybrids as an equity offering could be like manna from heaven for some debt-laden companies looking to raise capital. The concern for investors is that since hybrids stand behind all other creditors, they could be all but worthless in a bankruptcy filing.

Also, there's the possibility of a company failing to act on its promise to buy back a perpetual hybrid, or suspending payment on the bonds.

"The investor in a hybrid has to be concerned he may get caught holding this perpetually, instead of being taken out in 10 years,'' says Lapson. "We hope investors are considering that risk."

If you liked this article you might like

SEC Charges Ex-CIBC Broker

SEC Charges Ex-CIBC Broker

Durus Manager Gets Hard Time

Durus Manager Gets Hard Time

Shift for SAC's Cohen

Shift for SAC's Cohen

New Frontier Holder Selling

New Frontier Holder Selling

PIPE Deal Shines Up Sun

PIPE Deal Shines Up Sun