Hybrid Securities

Hybrid securities are those sets of securities that combine characteristics of two or more types of securities, usually both debt and equity. These securities are generally bought or sold via an exchange or broker.

These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offerings. 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.

Hybrid securities are a particular type of financial security that possess both the characteristics of debt and equity. They are a combination of different types of financial instruments. Due to this reason, they are referred to as hybrid. This kind of combination allows the investors a diversity in investment and is helpful in attaining financial objective through limited risk.  

Best hybrid securities reflect a different perspective for investors looking for additional return components and want to diversify their portfolios. They usually offer great potential for higher returns in a normal market scenario. On the downside, hybrids are riskier investments in general due to many risk factors that we have discussed.

Investors should carefully analyze and research individual issues before investing and look for predictive analysis for future market scenarios. They are generally riskier than equities and less risky than traditional fixed-income securities. It offers an additional interest component with higher risk, generally higher than average debt issues.

The 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. This allows the investor to benefit from appreciation in stock prices and earn profits.

However, depending on the terms and conditions, the dividend of the interest can be fixed or floating. But the issuer has to be financially stable to issue this kind if security. Such instruments can also be callable by the issuer before maturity, providing a flexible capital structure.

Above all, the investor must understand that it is important to research the issuer before making an investment. The investor should be well informed about any changes in rules and regulations that affect the performance of the valuation of these securities. However, their securities are an opportunity to maintain a balance between return and risk where there is a steady income as well as change to take advantage of capital appreciation.

Some important features of such securities are as given below:

• They often have a combination of debt and equity in their structure. This offers the investors a good option to get regular income and take advantage of market volatility and earn return at the same time.
• Many of the best hybrid securities have the option of getting converted to common stocks of the company issuing the same or may be called back before maturity. This may be a reason for risk for the investors but a reason for flexible capital structure for the issuing company.
• They may or may not have a maturity date, which depends on the type of security used in designing the instruments.
• Since it not totally debt, it faces a subordinate position while making priority of payment during bankruptcy of liquidaton. However, investors get a higher compensation for the same.
• These instruments are sensitive to changes in interest, liquidity or volatility, affected by credit risk and regulatory changes. This is because they affect the return and risk profile, the attractiveness of the investment and the method in which they are recorded in the books.

However, these features any financial institution of bank hybrid securities even though general in nature, and change depending on the nature of the combination of securities used in making it hybrid. Investors should thoroughly understand the features before investing in them.

Let us look at some common types of securities that are hybrid in nature.

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. The basis of the price is the prevailing market rates, the issuer's credit quality, and common stock (conversion premium).

For example, the 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 exposure to the company's stock, she would have 100 ($1,000/ $10 = 100) shares of the 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. 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.

We will look at some of the risks involved with these bank hybrid securities.

#1 - Trigger Events

Certain scenarios are coined as "Trigger Events" that define if security will undertake its intended mechanism or not. For example:

• Loss of earnings can cause interest payments to defer and 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 uncertainty. It can trigger the conversion of debt securities into equity at unfavorable terms to investors.

#2 - Volatility

Market volatility, 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 list 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 liquidity and increase that particular security risk level.

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

#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 usually not secured against the company's assets. That means secured, and other senior issues will have precedence over hybrids if the company goes into repayment procedure or, worse, into bankruptcy. They're also ranked lower in the event of repayment being triggered.

#4 - Prepayment Risk

Many hybrids are issued as Callable/ Redeemable, meaning 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 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.

Let us take the example of Max who is a salaried person with a family. His income is quite high as compared to his peers. So even though he has a family to provide for, he can afford to take some amount of risk and aim for higher return apart from regular dividend income which is quite low due to very less risk.

So he invests in a hybrid financial instrument that offers the features of a bond with convertibility of some portion of it to common stocks. This gives him a steady income as well as expose to financial market return.

These kind of hybrid securities list offer a good combination of investment opportunity that has both advantage and disadvantage. Let us study the advantages of the same first.

• 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: This 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 market price volatility than 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 lower 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.

Some disadvantages of the concept are as given below.

• Complex – The combination of securities used are complex and may require good understanding of each type to be able to identify the best combination. This often becomes difficult for small retail investors who may not have so much detailed knowledge.
• Misstatement – The above point leads to the fact that there is a possibility of misrepresentation of mispricing of financial instruments sincc ethe investors may not understand the concept skillfully. This increases the rrisk and also there is a possibility of less return than expected.
• Various risks – These instruments have the inherent risk of volatility of securities, risk of interest rate fluctuations, and also the risk of instruments being called by the issuer for redemption. Such instruments offer higher returns but are not suitable for investors who are looking for steady cash flow.
• Regulatory changes – This affects the performance and investment of such securities because the accounting standards and regulations influence valuation of securities by any company of financial institution.
• Lack of voting right – There are many such instrumets who do not offer any voting right to the investor due to the specific characteristics of instrument they have in them.

Thus, they offer very useful investment tools for any type of investor. However, it is necessary to have a good understanding of the risk levels and return opportunity to ensure that the financial goals are met within limited risk.

This article has been a guide to what are Hybrid Securities. We explain them with example, types, advantages, disadvantages, features & risk involved. You can learn more about investment banking from the following articles –

• What is Prepayment Risk?
• What is Convertible Arbitrage?
• Dilutive Securities Definition
• Private Placement of Shares Meaning
• Stockholders Equity Statement