Hybrid Securities

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 bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more 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. 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. It allows investors to earn a fixed interest rate and also to take exposure to the company’s stock.
Hybrid Securities

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Types of Hybrid Securities

Type #1 – Convertible Bonds

dilutive securities - 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. Basis of the price is the prevailing market rates, the credit quality of the issuer, and 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, she would have 100 ($1,000/ $10 = 100) shares of company Awesomely Growth Inc.

Type #2 – Convertible Preference Shares

convertible-preferred-stock

Similar to convertible bonds, convertible preference shares allow investors to keep the benefits of regular preference shares. These 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. They get stock-like features embedded into the notes themselves. 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.

Risks Involved with Hybrid Securities

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#1 – Trigger Events

Certain scenarios are coined as “Trigger Events” that define 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. It 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 uncertainly. It 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. It creates uncertainty around security’s future performance. 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.

Several factors can trigger it. E.g., changes in interest rates in general, changes in a company’s profitability or prospects, market sentiments, etc.

#3 – Liquidity Risk

Most hybrid securities trade through an exchange or a broker. However, their trading volumes can differ exponentially based on their respective demand and supply. It can create further uncertainty around liquidityUncertainty Around LiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more and increases the risk level of that particular security.

In general, investors need to have liquidity around their exposure. This way, they can easily buy or sell these securities whenever they require.

#3 – Unsecured

As we have discussed so far, hybrid securities are generally debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more 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. It usually happens with changes in interest rates in general.

If the interest rates are low, the company will try to repay its existing debt securities with higher interest rates and replace them with new securities at cheaper rates. It 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: Allows diversifying a portfolio through a single instrument, reducing the overall risk element. 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.

Conclusion

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 factorsRisk FactorsRisk factors in Business are constituents, circumstances, or causes, responsible for interruption, or, disrupting the business activities or operations, expectations, plans, objectives, or strategies of a business or an investor.read more 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 appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more, hybrids offer a great deal of investment opportunity for investors in general and also to those who look for certain event-driven opportunities.

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