Education Series - Hybrid Securities

What are they?

Hybrid securities are also commonly known as hybrids. They represent a type of tradable financial security that brings together features of both debt and equity. Their buying and selling takes place either on a stock exchange or through an equity firm.

Hybrids are like debt as they pay regular income and carry a notional value. For instance, if you invest £100, then at the end of the term, you should get back the same amount.

On the other hand, they are also like equity as they are classified as capital by the issuer and are traded on the stock exchange. Additionally, just like an equity stock, they involve risk and the investor might lose all of his investment.

Hybrid securities should be understood closely before making an investment decision in these, as they are relatively complex in nature, especially for a new investor.

Who issues them?

Generally, banks, corporate, and insurance companies issue the hybrid securities.

What kind of returns do they provide?

The return of a hybrid security will typically by higher than that of a pure bond and lower than that of a pure equity stock. They are riskier than a bond but less risky than an equity.

Hybrids can provide either a fixed or a floating type of return to their investors. This return could be paid either in terms of interest of dividend or both. For most hybrid securities, you get an option to convert them into a share.

Normally, the return on a hybrid security can be split up into two parts – a fixed income and a variable income component. Generally, the fixed component is paid annually till the date of maturity. Fixed component is only a part of the face value of the hybrid. The rest is the variable income, which is dependent on some other set of securities.

Few hybrids also provide tax benefits to their investors, while some of them pay you their face value after maturity.

Types of hybrid securities

There are essentially three types of hybrid securities, namely the convertible bonds, convertible preference shares, and capital notes. Let us discuss each of these one by one.

1. Convertible bonds

As the name suggests, a convertible bond or security will provide its investor with an option to convert them into some other kind of security, which is mostly the company’s shares, within a fixed time period. These bonds are issued by a publicly listed company. In a way, they are offensive yet defensive as they combine the characteristics of both stocks and bonds. These bonds will typically have a maturity date and a stock-conversion price.

So, why would an investor be interested in the convertible bonds? The answer is simple. In a low-interest environment, convertible bonds behave like bonds, and provide attractive coupons. One should not forget that stock investors might not be paid dividend if the company runs into any difficulty and decides to forego the dividend. On the contrary, by investing in convertible bonds, the investor can enjoy a steady stream of coupon income. In addition, these bonds are subject to lower downside risk. But at the same time, they can freely participate in most of the upside of stocks.

A convertible bond can be of two types – with either a holder or an issuer option. In the first type, the investor is allowed to select if he wishes to convert it into the underlying company shares. While in the case of the latter, the underlying company and not the investor holds the same right, i.e. converting the bond into shares. The interest rate paid to the investor is more in the issuer option type convertible bond.

2. Convertible preference shares

The preference shares differ from ordinary shares in the fact that pay a specified (fixed or floating) dividend rate to their investors. In case of a floating rate, the dividend payments vary accordingly. These shares typically pay out regular payments to their buyers, adding to its attractiveness.

On the other hand, the dividend rate for the ordinary shares is variable in nature. Whenever the company decides to pay dividends to its shareholders, the holders of preference shares are the first ones to be paid. Further, if the company is facing any solvency problems, investors holding preference shares will be paid before the holders of common shares.

However, in most cases, dividends are not tax deductible in case of the convertible preference shares. In addition, the amount of dividend received by these convertible preference shareholders is usually different from the amount given to the ordinary shareholders.

Similar to a bond, the preference shares may be converted into cash at the time of maturity. They can also be exchanged for the shares of its company. So, on maturity, you are guaranteed either a cash payment or a common stock.

3. Capital notes

Capital notes are typically debt securities, but with attached characteristics like that of an equity. If you buy a capital note from a company, you are mainly lending it money for a fixed-term. In return, the company will give you regular interest till the date of maturity, after which you will get back your principal amount.

Capital note is a type of unsecured debt and is ranked lower than any secured debt. What this means is that if the company goes bankrupt, the secured debt holders will be paid first, hence they carry a risk.

The capital notes can be of three types – perpetual debt, sub-ordinated debt or knock-out debt securities.

A perpetual debt security does not have a set maturity date, which is a feature similar to that of a share, or an equity.

The sub-ordinated debt security is a type of hybrid security that ranks lower than other senior securities, and is liable to claim its earnings only after that on the senior ones has been paid. For this reason of being the last to be paid in line, the sub-ordinated debt securities are riskier that non-subordinates ones.

Finally, as the name suggests, a knock-out debt security gives the issuer a right to knock it out under some terms and conditions.