Hybrid Securities Meaning
Hybrid securities are those set of securities that combine characteristics of two or more types of securities, usually both debt and equity components. These securities allows companies and banks to borrow money from investors and facilitate a different mechanism from the traditional bond or stock offering. These securities are generally bought or sold via an exchange or through a broker.
- They are generally riskier than equities and less risky than traditional fixed income securities and with higher risk, it offers an additional interest component, generally higher than normal debt issues.
- A most common type of hybrid security is convertible bonds, which allow investors to earn a fixed interest rate and also to take exposure to the company’s stock.
Types of Hybrid Securities
Type #1 – Convertible Bonds
Convertible Bonds offer a higher rate of return with an opportunity to invest in the company’s stock. These bonds usually offer a coupon rate, generally higher than normal debt securities and the prices are based on prevailing market rates, the credit quality of the issuer, and future prospects of the common stock (conversion premium).
For example, company Awesomely Growth Inc. has issued convertible bonds with a par value of $1,000 and a stock conversion price of $10. If the bondholder wants to execute this conversion and wants to take exposure to the company’s stock, then she would have 100 ($1,000/ $10 = 100) shares of company Awesomely Growth Inc.
Type #2 – Convertible Preference Shares
Similar to convertible bonds, convertible preference shares allow investors to keep the benefits of regular preference shares and earn regular or steady dividends, with an opportunity of earning a higher return by converting into the company’s common stock.
These securities offer a fixed or floating rate of dividends with the option of earning higher returns through future growth prospects if converted into common stocks.
Type #3 – Capital Notes
These are generally debt securities that have equity-like features. Unlike convertibles, investors usually don’t get their investments converted into stock but get stock-like features that are embedded into the notes themselves. For e.g. subordinated debt securities, Knock-out debt securities, perpetual debt securities, etc.
Risks Involved with Hybrid Securities
We will look at some of the risks involved with these Securities.
#1 – Trigger Events
There are certain scenarios that are coined as “Trigger Events”, that defines if security will undertake their intended mechanism or not. For example:
- Loss of earnings can cause interest payments to defer and can drastically affect the expected returns from that security.
- Regulatory or changes in tax laws can affect the expected return on hybrid security and can even trigger immediate suspension of debt securities earlier or later than expected.
- Changes in the financial health of the organization can affect the returns in an uncertain manner and can trigger the conversion of debt securities into equity at unfavorable terms to investors.
#2 – Volatility
Volatility in markets especially around security’s price can affect the expected returns and can create uncertainty around security’s future performance. For e.g. a convertible bond is trading on an exchange and its price has fallen way below its original par value of $1000 to a market value of $840.
This can be triggered by a number of factors e.g. changes in interest rates in general, changes in a company’s profitability or future prospects, market sentiments, etc.
#3 – Liquidity Risk
While most hybrid securities are traded through an exchange or a broker, their trading volumes can differ exponentially based on their respective demand and supply. This can create further uncertainty around liquidity and increases the risk level of that particular security.
In general, it’s very important for the investors to have liquidity around their exposure so that we can easily buy or sell these securities whenever they require.
#3 – Unsecured
As we have discussed so far, hybrid securities are generally debt instruments with an added feature of equity components. These securities are generally unsecured and are usually not secured against assets of the company. They’re also ranked lower in the event if repayment is triggered. That means, secured and other senior issues will have precedence over hybrids, if the company goes into repayment procedure or worse, into bankruptcy.
#4 – Prepayment Risk
A lot of hybrids are issued as Callable/ Redeemable, which means, companies can call and redeem a bond offering if they deem fit. This usually happens with changes in interest rates in general.
If the interest rates have been lowered, the company will try to repay its existing debt securities with higher interest rates and replace them with new securities at cheaper rates. This also creates uncertainty around the viability of these securities and affects their expected returns.
Advantages of Investing/Issuing in such securities
- Higher Returns: Generally offers higher returns than traditional bond offerings. Also, provide an opportunity to participate in a firm’s growth if there is an uptick in the company’s common stock.
- Diversification: Gives an opportunity to diversify a portfolio through a single instrument, reducing the overall risk element. For e.g. adding a hybrid to a traditional stock-bond portfolio reduces the overall risk and adds diversification.
- Volatility: Though volatility is a risk element with hybrids, it generally has less volatility in terms of market price as compared to traditional stocks. Since these securities provide a steady income stream, they are usually less volatile.
- Cost of capital: By combining the benefits of debt and equity, hybrids usually lowers the overall cost of capital for the issuer. Additionally, the issuer benefits through hybrid bonds as they have minimal impact on their overall credit rating.
Hybrids reflect a different perspective for their investors who are looking for additional return component and want to diversify their portfolio. They usually offer great potential for higher returns in a normal market scenario. On the downside, hybrids are riskier investments in general due to a lot of risk factors that we have talked about.
Investors should carefully analyze and research on individual issues before investing and also look for predictive analysis for future market scenarios.
With recent market developments and increasing risk appetite, hybrids offer a great deal of investment opportunity for investors in general and also to those who look for certain event-driven opportunities.
This has been a guide to Hybrid Securities and its meaning. Here we provide the different types of hybrid securities and understand the top 4 risks involved as well as their benefits. You can learn more about investment banking from the following articles –