What is Hybrid Security?
Hybrid Securities are securities that have dual characteristics of debt and equity, issued generally by corporations, offering the investors a fixed or variable rate of return in the form of interest or dividends, sometimes returning the face value to investors or converting the securities into pure equity.
Types of Hybrid Securities
#1 – Convertible Bonds
As the name suggests, a convertible bond is a bond that can be converted into another form of security, generally equity security. Convertible bonds offer a regular stream of income with an option for the investors to convert the bonds into equity at a later date in a pre-specified conversion ratio.
The bondholders are paid as per the schedule at all times and in circumstances when the conversion is due, the security could be converted into equity. Once converted, the securities behave like common equity shares and no fixed payments are made by the issuer.
#2 – Convertible Preferred Shares
Similar in characteristics to convertible bonds, convertible preferred shares can be converted into equity shares at a pre-specified price. Preferred shares generally pay fixed or floating dividends. However, these shares are riskier than convertible bonds because the bondholders get priority over shareholders in the event of a default by the issuing company.
#3 – Mezzanine Debt Securities
Mezzanine debt securities give the right to the lender to convert its debt into equity in case of defaults. These debt securities can be senior to equity shareholders (with some exceptions) but can be subordinate to vanilla debt securities. These debt securities get a high rate of interest (between 12-20%) and are more customized to suit the need of the borrower. Mezzanine debt can be taken for individual projects that have a long-term tenure of payback.
#4 – Capital Notes
Capital notes are debt securities with equity-like features, in which, the holders of this debt are subordinate to many other classes of debtors and creditors. This accords them with equity-like features. Perpetual Debt Securities, Subordinated debt securities and Knock-out debt securities are some examples of Capital Notes
Hybrid Security Example
Company A issues a convertible bond with a par value of $1,000, convertible into equity shares at a predetermined price. If the conversion price is $10, the bondholder will get 100 ($1000/$10) shares if he chooses to convert the bonds into equity shares. These bonds can also be issued with a call feature which allows the issuing company to redeem the bonds before maturity.
Advantages
- Hybrid securities are less volatile compared to pure equity securities as they comprise benefits of debt, in the form of regular, predetermined interest or dividend payments
- Hybrid securities generally earn a higher rate of return than plain debt securities because these securities are subordinate (riskier) to plain debt securities. Hybrid securities are paid a high dividend or interest rate up to conversion.
- It helps diversify the risk of the investors due to their dual characteristics of equity and debt
- Hybrid securities offer further diversification benefits when combined with other investments in the investor’s portfolio
- The issuers of debt are benefitted by hybrid securities as they lower the cost of capital and do not impact its credit rating much
Disadvantages
- The foremost disadvantage of hybrid securities is its complexity. Due to their complex nature, it is difficult for a common investor to understand and invest in them
Risks Involved in Hybrid Securities
- Hybrid securities carry a prepayment risk as the companies try to redeem the securities before they become eligible for conversion to reduce the dilution in equity ownership
- This generally carries a high degree of default risk and can result in the complete loss of capital for investors in some cases because these securities are generally unsecured
- This may not have a market as active as it is for other securities making it difficult for investors to increase or reduce exposure to hybrid securities
Important Points
- This is risky and contains a number of customized terms which could be different in every other issuance making it difficult for investors to comprehend the nature of the securities
- Rates of hybrid securities depend on the general market conditions and the credit quality of the insurer.
- The price of hybrid securities trades in accordance with the price of equity shares once they are in-the-money. It means that the hybrid security prices move in tandem to the price of equity shares if the conversion price of hybrid security is lower than the prevailing market price of the equity shares.
- This can also be issued with cumulative or non-cumulative features, meaning, the missed dividend and interest payments are paid to the shareholders at the next payment date in cumulative structure and are forgone in case the securities are non-cumulative.
- Hybrid securities can also be redeemable and non-redeemable, meaning the company offers to redeem the security at a later date if it is redeemable while not offering any redemption when the issued securities are non-redeemable.
- It also comes with a reset feature, in which the dividend rate and the next reset date are determined at every reset date
Conclusion
- It allows investors to invest in multiple kinds of securities by taking exposure in only one kind. This is beneficial to investors in isolation as well as from the overall portfolio perspective due to the diversification benefits that come along with these securities.
- On the flip side, the complexity of these securities makes it difficult for a common investor to understand the nuances of this investment. There are too many technicalities involved in designing the issuances for convertible or hybrid securities making it an investment choice of a selected few seasoned investors.
- For investors looking to profit from complex, event-driven investing opportunities, investing in hybrid securities can be a full-time career. Hybrid securities provide interesting investment opportunities in times of extraordinary uncertainties.
- These investors are generally on the lookout for anomalies between the price of hybrid security and the price of equity shares to profit from the mismatch.
- Finally, one should understand the risks fully before investing in any kind of hybrid security and invest only when the risk-reward ratio is favorable.
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