What is Hybrid Securities?
The term “hybrid securities” refers to the financial instruments that exhibit the characteristics that are mix of both equities and bonds, i.e. it will generate returns which is akin to either the performance of a company(like equities) or astable rate of return (like bonds).In other words, hybrid securities offer guaranteed payment like a bond while it also shows the potential for capital appreciation just like a stock.
The two most popularly known categories of securities are equities (variable income securities)and bonds (fixed income securities). The purchase of equities offer partial ownership of a company, while bonds means lending money to a company and receiving interest as a form of fixed income. Now, hybrid securities are a combination of both security types (equities and bonds) and their return is based on the performance of the underlying assets.
Features of Hybrid Securities
The features of hybrid securities are as follows:
- They usually offer a higher rate of return than pure fixed income securities, but the return is lower than that of pure variable income securities.
- They are believed to be less risky than pure variable income securities, but riskier than pure fixed income securities.
- Investors can use these securities to participate in a company’s capital raising program without having either the risk of a stock or less liquidity of a bond.
Types of Hybrid Securities
The hybrid securities are broadly categorized into three types – preferred stocks, in-kind toggle notes, and convertible bonds.
- Preferred Stocks: In this type of hybrid securities, investors enjoy seniority to common stockholders and as such receive dividends before them. So, preferred stocks are considered to be less riskier than common stocks. The quantum of dividend for preferred stocks is usually different from that of common stockholders. In case of insolvency, the businesses are obligated to repay the preferred stockholders prior to the common stockholders. Additionally, at times preferred stockholders are offered the option to convert their holdings into common stocks.
- In-kind toggle Notes: This type of hybrid securities helps companies, which are undergoing a liquidity crunch, in raising capital to fund the short term liquidity gap. In such securities, the issuing company have the option to capitalize on the interest payment that results in additional debt. Basically, in-kind toggle notes come with the provision to delay the payment of interest during times of serious liquidity shortfall.
- Convertible Bonds: This type of hybrid securities is fixed income instruments that have a call option on some equity. Effectively, the investors of these securities have the option to convert their holdings into pre-determined number of stocks of the company. In fact, in some cases, the investors also have the option to convert the fixed income instrument of one company into a fixed number of stocks of some other company. This special variant of a convertible bond is known as an exchangeable bond. Typically, the rate of return offered on convertible bonds are less than that of traditional fixed income bonds and the interest rate differential is what the convertible bondholders pay as premium for the call option.
Risks of Hybrid Securities
Some of the major risks associated with hybrid securities are as follows:
- They are generally not secured against any of the company’s assets.
- There is huge liquidity risk in such securities as the trading volumes can vary significantlydriven by their demand and supply in the market.
- The expected return is exposed to volatility in market price, which is usually very unpredictable.
- If the issuing company incurs loss of earnings, then the interest payment of these hybrid securities can get effected drastically due to other senior debt obligations.
- The return on these securities is also exposed risk of regulatory changes or changes in tax laws.
Some of the major advantages are as follows:
- These securities usually offer a return that is relatively higher than other senior obligations as hybrid securities are often subordinated in the capital structure.
- Hybrid securities exhibit relatively lower volatility than the overall market as they offer stable and fixed distribution of market returns.
- Hybrid securities can have a diversified risk profile as they are not bound by any strict requirement to stick to either equities or bonds.
Some of the major disadvantages are as follows:
- Investment in hybrid securities is considered to be complicated compared to investments in either equities or bonds.
- Since it is subordinated to other senior obligations, it can incur significant losses in case the issuing company runs into bankruptcy.
Important Terms About Hybrid Securities
The following are some of the important terms that can be associated with hybrid securities:
- Reset Date: It refers to the date on which the terms and conditions (interest rate, next reset date, etc.) of the hybrid securities may change.
- Cumulative Dividend: In this system, if the issuing company is unable to pay the dividend in a particular period, then it gets added to the next dividend payment.
- Non-Cumulative Dividend: In this system, if the issuing company is unable to pay the dividend in a particular period, then it is waived off.
- Redeemablesecurities: In this case, the holder of the securities has the option to sell it back to the issuing company at the issue price.
- Non-Redeemable Securities: In this case, the holder of the securities doesn’t have the option to sell back.
So, it can be seen that the concept of hybrid securities is new, which is a mix of both equities and bonds. Companies prefer using these financial instruments to raise capital given its various advantages. Investors also fancy hybrid securities as it offers a relatively fruitful balance of risk and reward.
This is a guide to Hybrid Securities. Here we also discuss the introduction and features of hybrid securities along with advantages and disadvantages. You may also have a look at the following articles to learn more –
- Hedge Fund strategies
- Stocks vs Mutual Funds
- Objectives of Financial Statement Analysis
- Corporate Finance