May 2 (Bloomberg) -- Hybrid securities sales may reach a record of at least $125 billion this year as banks and brokers seek to replenish capital following losses from the collapse of the subprime mortgage market.

More than $19.5 billion of sales last month by banks including Citigroup Inc., the biggest U.S. bank by assets, and Bank of America Corp., the second-largest, put new issues of the debt on pace to top last year's $115 billion, Merrill Lynch & Co. strategist Kevin Conery forecasts.

Conery estimates sales of $125 billion, while James Merli, global head of debt syndicate at Lehman Brothers Holdings Inc., said sales may reach as much as $135 billion. Financial institutions are selling the securities, which combine characteristics of debt and equity and typically count as regulatory capital, to bolster their balance sheets after taking $319 billion in asset writedowns and credit losses since the beginning of 2007.

``The hybrid is a way to balance raising capital between the debt markets and the equity markets,'' said John Tierney, credit strategist at Deutsche Bank AG in New York. ``They can get credit for capital from the rating agencies and from the regulators. They have to build capital and they're just wary of raising too much equity because of the dilution.''

Deutsche Bank offered $1.1 billion of trust preferreds this week. Charlotte, North Carolina-based Bank of America sold $4 billion of hybrid bonds on April 24, three months after raising $6 billion of the notes in another offering. Citigroup issued $6 billion of perpetual preferred securities on April 21.

Investment Grade

The surge in hybrid sales in the institutional market helped push investment-grade corporate bond sales to $122 billion in April, the second-biggest month ever, according to Bloomberg data. Banks and securities firms have raised $231 billion of capital through shares or subordinated debt since July.

Corporate bond offerings topped $30 billion for the third straight week, ranking the period as the fourth busiest this year, Bloomberg data show. Sales totaled $30.1 billion, as Dearborn, Michigan-based Ford Motor Credit Co., the automaker's finance unit, and Zurich-based bank Credit Suisse Group issued debt. Sales have averaged $19.6 billion a week this year and reached $45.7 billion last week, according to Bloomberg data.

The extra yield, or spread, investors demand to own investment-grade corporate bonds narrowed 14 basis points this week to 253 basis points, the biggest weekly drop in five years, Merrill Lynch index data show. High-yield spreads tightened 20 basis points to 664 basis points, the lowest since Jan. 10, according to Merrill. High-yield, or junk, debt is rated below Baa3 by Moody's Investors Service and lower than BBB- by Standard & Poor's. A basis point is 0.01 percentage point.

Defer Interest Payments

``The fact that the market has continued to provide as much capital and liquidity to the large financial institutions as they have is pretty impressive,'' Merli said. ``That's the half-full version. The half-empty version is it's become increasingly more attractive from the buy-side's perspective and increasingly more expensive from the issuer side.''

Hybrids typically allow issuers to defer interest payments without defaulting and rank behind senior bonds for repayment in a bankruptcy. The securities may have no maturity and credit- rating companies usually give the securities equity credit, meaning only a portion of the money raised is counted as debt on an issuer's balance sheet.

Banks and brokers may be too reliant on this form of capital, said Tanya Azarchs, an analyst at S&P in New York.

``It's a lesser-quality form of capital than straight equity is and so we don't like to see more than a certain amount of each type of instrument in there,'' Azarchs said. ``A lot of it that's been recently raised we're not counting.''

Moody's Limits

Citigroup has about $47 billion of preferred and hybrid capital and only gets equity credit from S&P for $28.5 billion of it, she said. S&P assigns varying amounts of equity credit to different types of hybrids. Issuers may have as much as half of their equity in mandatory convertible preferred shares and as much as 33 percent in perpetual preferred securities, she said.

Moody's said in March it was limiting the amount of equity credit granted to hybrids to 25 percent of a company's total equity. Merrill, which issued $2.55 billion of perpetual preferred shares this month, has too much hybrid capital and must raise common equity to bolster its ratios, Moody's said in a report this month. Moody's is reviewing New York-based Merrill's A1 rating for a downgrade.

``The whole issue with hybrid securities is the banks can elect to stop payments in times of stress without precipitating a default,'' Azarchs said. ``Banks are very reluctant to do that. They'll pay the preferred dividend even when they can't cover it with current earnings and it's usually at a regulator's encouragement that they stop payment on a preferred and at that point they're already in trouble.''

Liquidity Premium

New York-based Citigroup, which also sold $4.5 billion of common stock this week, cut its dividend by 41 percent in January to preserve capital.

Preferred stock and hybrid securities have returned 11 percent this year, compared with a 0.7 percent return for the average investment-grade corporate bond, according to Merrill index data.

Hybrid securities are attractive because they offer extra yield, said Manny Labrinos, who helps oversee $2 billion in fixed-income assets as head of corporate bond trading at Nuveen Investment Management in Los Angeles. The perpetual preferred securities Merrill issued on April 22 were priced to yield 8.625 percent, compared with a coupon of 6.875 percent on $5.5 billion of 10-year debt issued the same day.

``There continues to be demand but it's charging a big premium to get that liquidity,'' said Lehman's Merli, who is based in New York. ``No one is doing this because it's opportunistic or attractive from a historical perspective or any of that. They're doing it because they have to raise capital.''

To contact the reporter on this story: Caroline Salas in New York at csalas1@bloomberg.net

Last Updated: May 2, 2008 18:08 EDT