The investment in Hybrid securities is inherently complex as there are a combination of features found in debt as well as an equity instrument. Moreover, investments in these hybrid securities suffer from the following major risks:
Interest Rate Risk:
One of the noteworthy things while investing in hybrids is that such securities cannot be a substitute instrument for garnering the fixed income as the income strips from these instruments are less assured while the value of the principal which is typically repaid in the case of the debt instrument has been much volatile, more like holding an equity instrument. In case of a hybrid instrument whose features are more tilted towards an equity-like instrument, investors are exposed to higher risks in the form of interest payments i.e., coupons which could be deferred & it might also possibly not be accumulative in nature. Moreover, the principal repayment date could be deferred, or in the event of a default, repayment of principal is subject to there being any residual value after other higher-ranking creditors have been fully repaid. This phenomenon is exacerbated if held alongside a predominantly equity-weighted portfolio given the positive correlation between equities and hybrids during periods of weak equity markets. The interest in senior debt securities, on the other hand, cannot be deferred without triggering an event of default.
It is the risk of the issuer defaulting on its payment obligations of either principal or interest. Having the rating agencies treat the instruments as equity-like is supportive of the issuer’s credit ratings and allows them to reduce the need to raise equity.
It is pretty evident that investing in hybrid instruments exposes investors to higher credit risk. Furthermore, based on the issuer’s business and financial profiles, we can say on a rough basis that that most of the hybrid universe has a sub-investment grade credit rating profile.
Hybrid instruments tied to issuers with weaker credit profiles which would have further doubts raised over their ability to maintain coupon payments, whilst their capital values would be affected by low recovery rates in the event of default.
In simple words, if an investor does not believe that the issuer is creditworthy, then he shouldn’t invest anywhere along its capital structure. Assuming that, if the issuer is creditworthy, then the investor should only invest in hybrid instruments if he believes that he is getting fully compensated for taking the higher risks.
An Investor must also undertake relative value analysis whereby the risk-reward framework of hybrid security should be compared against senior and subordinated debt securities. These measures must be favourable for hybrid instruments before an Investor should look upon them to invest.
It is the risk that the hybrid instruments would not be available to be traded freely even though they are traded on the exchange, which could ultimately impact the pricing of the security. Lack of liquidity impacts the possibility of frequent buying and selling in these securities. Moreover, the hybrids are typically less liquid when compared with the equity shares due to their complex nature. Hence, if one needs to buy or sell these instruments immediately, then he won’t be able to do that and may have to accept a lower price due to the lack of liquidity.
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