What are hybrid securities?
Hybrid securities are those securities which possess the features of both debt and equity. It is single security with the characteristics of debt and equity. Investors prefer hybrid securities as these are safe as compared to other securities. Also, these securities on maturity give the investors either fixed or floating rate of interest. It is also possible those investors who are holding these securities may receive a return in the form of a dividend.
Types of Hybrid securities:
There are three types of hybrid securities:
- Preference shares
- Capital notes
From the name itself, convertible allows the holder of the security to convert its form. If we further elaborate, suppose an investor is holding a convertible bond, then he /she can convert the bond into shares of that company only till the bond matures. Investors prefer to keep convertible bond into their portfolio as it is a flexible option for financing. Not just the investors but the companies also get benefitted in a case where the share is overvalued. In this scenario, the companies issue convertible bonds which the bondholder can easily convert in the form of equity. However, the rate of interest is low in case of these convertible bonds.
The risk associated with the convertible bond is during the period when the company is giving a poor performance. In that case, it might land itself in a position where it is neither able to pay the face value of the security when it matures nor the coupon rate. There are other risks associated with the debt securities are late payment of the interest, volatility in the market price, the company is going to be insolvent, early repayment, and illiquidity.
As the name suggests, the preference shares just like convertible bond pay fixed or floating rate of interest. The preference shareholders of the company hold preference shares who receive fixed or floating return much before the ordinary shareholders. It can also be exchanged with the underlying company’s stock. The preference shareholders also have voting rights in certain circumstances. In case of bankruptcy, preference shareholder gets an advantage over the ordinary shareholders as they will be entitling to receive the payment before the ordinary shareholders.
The risk associated with the preference shares is that in case the company is underperforming there could be a chance that they might not receive any dividend. The other risk associated with the preference share is interest risk, currency fluctuation risk. In case, the company issues new preference shares at an interest rate higher than its previous interest rate, and then there is a situation of interest risk.
Currency fluctuation risk arises due to fluctuation in the exchange rate.
Capital notes are debt security which possesses the features of equity. It is being issued by the company to clear its short-term debts. Under capital notes there are three debt-securities:
- Perpetual debt securities- These securities do not have any fixed maturity date.
- Subordinated debt securities- These securities have fewer rights to receive interest and repayment of principle as compared to other debt instruments during winding up of the company.
- Knock-out debt securities- These debt securities get issued by the banks or other prudentially-regulated companies which gives the issuer or the respective third party a right to destroy them under certain conditions
These are highly risky as compared to other secured corporate bonds as these have the lowest priority.