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A hybrid instrument is called as a hybrid, due to its nature to inculcate the characteristics of more than one financial instrument. One of the most prevalently used Hybrid debt instrument is an optionally convertible debenture/ bond or an option embedded bond. An optionally convertible debenture is a debenture whose value is not only derived by the kind of interest that it pays but is also significantly impacted by the price movements of the share into which it can be converted.
Coming to the option embedded bonds, these bonds have call or put options embedded into them. For e.g., if a corporation has issued a 8% $10 bond with a call option, then the company will be able to redeem those debentures even before the debentures get matured. So, if the interest rates have reduced post the issuance of these debts, then in such case it would become very likely that the company will refinance its debt. This would be done by issuing the new bonds at the lower interest rates and then utilizing those funds for the redemption of existing liabilities on account of the earlier bond issuance. From the perspective of an investor, the callable bond would always pay a higher coupon as compared to a straight bond. The price of a callable bond is generally lower as compared to the price of a straight bond as the price is a composite of price of a normal bond reduced by the price of a call option embedded with the bond.
There are also few disadvantages to the investors, one of the most significant of them is the exposure towards the reinvestment risk. It is because of the reason that the bondholder is getting exposed to the risk of reinvesting at a lower interest rate.
Similarly, a Put bond is a bond that provides a bondholder with a right to force the issuer to repurchase the bonds and at a date which is prior to the maturity of the instruments. The puttable bond is most likely to be exercised when the interest rates have risen in the markets & there remains a lucrative opportunity to invest in the other bonds at a much better and higher interest rate. Hence due to this special privilege that the investor gets, he has to settle for a lower coupon as compared to the straight bonds. The same way, the price of a puttable bond is higher than the straight bond as compared to a straight bond because the price of bond is an aggregation of straight price and value of the embedded put option.
The various terms and conditions subject to which these bonds are issued are typically incorporated in a bond indenture. The introduction of these hybrid instruments is due to the needs of the various sophisticated Investor. Hence these instruments heavily cater to a sophisticated and institutional investor. As these are highly complex financial instruments, it becomes increasingly difficult to categorize them as either debt or equity.
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