What is hybrid security?
Combining elements of many financial instruments into one security is known as a hybrid security. Hybrid securities, or “hybrids,” are financial instruments that exhibit debt and equity features. Convertible bonds, which combine the characteristics of regular bonds with those of the underlying stock, are the most prevalent form of hybrid asset.
A Clearer Picture of Hybrid Securities
Exchanges and brokerages facilitate the purchase and sale of hybrid securities. Investors can receive dividends or interest payments from hybrids, and they can set the rate of return as either fixed or variable. When they mature, some hybrids refund their face value to their holders, while others offer tax benefits. The intricacy and esoteric nature of hybrid securities make them potentially difficult to market.
Diverse Hybrid Security Structures
Convertible preference shares are another frequent hybrid product, alongside convertible bonds. The underlying company’s stock may exchange these shares and pay dividends at a fixed or variable rate before paying everyday stock payments.
As an extra hybrid security, pay-in-kind toggle notes allow the issuing firm to shift payment focus from interest rates to the investor’s new debt—in other words, the company owes the investor more money. Still, it doesn’t have to pay interest on it right now. However, if the firm cannot remedy its cash flow problem, the outstanding principal payment may never materialize, even while the interest deferment allows it to keep cash flowing.
There are distinct risk and reward profiles for each hybrid security type. While convertible bonds still include the risk of a bad underlying company’s performance, they pay less interest than conventional bonds and have a higher potential for gain. They may also be unable to pay back the bond’s face amount when it matures, in addition to missing coupon payments. Though convertibles have a higher potential for return on investment than traditional stocks, they are nonetheless vulnerable to a decline in value should the underlying firm fail to meet expectations. Hybrid instruments are associated with additional risks such as interest deferral, bankruptcy, market price volatility, early repayment, and illiquidity.
Special Considerations
Someone seems to devise a new hybrid security every day to appease the most discerning investors. The complexity of some of these assets makes it hard to classify them as either equity or debt.
Not only are specific hybrid securities confusing, but they also put investors at risk beyond what the profit they may get from them justifies. While ordinary investors aren’t the target market for hybrid securities, even large institutions make mistakes when purchasing these products.
