Hybrid Securities
What are Hybrid Securities?
Hybrid securities are a group of tradable investment instruments which combine the features of two or more type of securities, usually both equity and debt. These securities tend to give higher returns than the fixed income securities such as bonds, but lower returns than the variable income securities such as stocks. The security will have the assured payment feature of the bond, while at the same time it will have the opportunity for capital appreciation of the stock.
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Hybrid securities are complex investment instruments. They can be sold on an exchange or through a brokerage. Hybrid securities pay a fixed or floating rate of return till a certain date, at which point the security holder has a number of options, including converting the securities into underlying shares. They allow the issuing company to collect capital without requiring either the full commitment of the bond or the exposure of the stock offering. Some hybrid securities also provide a tax advantage to the holders.
Types/Examples of Hybrid Securities:
- Convertible Bonds: Convertible bonds are fixed-income debt security that can be converted into a predetermined number of equity shares. These bonds generally offer a higher coupon rate than normal debt securities. The price is based on prevailing market rates, the credit quality of the issuer, and prospects of common stock.
- Convertible Preference Shares: Convertible preference shares provide investors with regular or steady dividends as well as other benefits of regular preference shares. Along with this, it provides an opportunity of earning a higher return by converting into the company’s common stock.
- Capital Notes: Capital notes are debt securities with equity-like features. Unlike convertibles, investors do not get their investment converted into stock. The features of equity are embedded into notes themselves.
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Benefits of Hybrid Securities:
- Higher Returns: Hybrid securities usually offer higher returns than traditional fixed-income securities. In addition, it also provides an opportunity to participate in the company’s common stock.
- Diversification: Hybrid securities allow for the diversification of a portfolio using a single instrument and reducing the overall risk element.
- Volatility: Though volatility is a risk element for hybrids, it usually has less volatility in terms of market price compared to traditional stocks. As these securities provide a steady income stream, they are less volatile.
The risks involved with Hybrid Securities:
- Volatility: Volatility in securities price can affect the expected returns. It creates uncertainty about the future performance of the security.
- Liquidity Risk: Investors generally need to have liquidity so that they can easily buy or sell these securities whenever required. Usually, trading volumes differ exponentially based on their respective demand and supply. It creates uncertainty around liquidity and risk increases.
- Unsecured: As hybrid securities are debt instruments with added features of equity components, these securities are generally unsecured and are not secured against the assets of the company. They are also ranked lower in the event of repayment.
- Prepayment Risk: With interest rate changes in general, companies can call and redeem security offered if they deem fit. If the interest rates are lower, the company will try to repay existing debt securities with higher interest rates and replace them with securities at cheaper rates. It creates uncertainty and affects expected returns.
Conclusion:
A hybrid security is one that contains elements of different types of securities. It helps investors who are looking for additional returns and diversifying portfolios. They offer great potential for higher returns than normal scenarios. They typically include aspects of both debt and equity instruments that create a higher return rate but also a higher risk profile than ordinary security. Though hybrids securities are riskier investment instruments, investors should therefore carefully analyze them before investing in such instruments.
Author: Hetvi Shah
About the Author: Hetvi is a BBA(Finance) graduate. She is currently pursuing an MBA with Finance specialization. She has a keen interest in Financial Market, Financial Management, and Financial Analysis.
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