Capital is the lifeblood of any business, allowing it to operate and grow. However, the prevalence of standard investing among certain types of businesses can make it challenging to access capital.
Hybrid financing is a potential solution to this issue. According to the Collat School of Business at the University of Alabama at Birmingham, hybrid financing presents an opportunity for investors in the form of hybrid securities.
A hybrid security is a financial product that combines or has the features of two or more types of securities, which are any financial asset — a bond, stock, option contract or share of a mutual fund — that can be traded on the open market. Generally, hybrid securities have characteristics of debt and equity.
The most common securities found in hybrid securities are bonds, debt issued by companies or governments with defined interest rates and dates for repayment and stocks or equity issued by a company that gives partial ownership in the company.
While hybrid financing can provide businesses with both capital and regulatory and tax benefits, hybrid securities can benefit investors by diversifying their portfolio of investments and providing a lower level of risk.
How Do Hybrid Securities Work?
The two main types of securities are debt and equity. Hybrid securities combine elements of these two ends of the financial continuum into one investment product.
You can buy and sell hybrid securities on an exchange or through a brokerage. Depending on the type, companies issuing the security may pay a fixed or floating rate of return, and you’ll often receive your return in the form of interest payments or dividend payments.
The debt and equity in hybrid securities carry out the same characteristics as their underlying securities, giving you the sense of a guaranteed payment over a fixed period and providing the potential to see capital gains if the stock price increases.
Types of Hybrid Securities
Several hybrid securities are available for you to consider, and more are being created all the time to meet the needs of companies looking to raise capital.
Convertible Bonds
The most common among hybrid securities is the convertible bond. Like a typical bond, it pays interest and has a guarantee, but its value is tied to the issuer’s stock price. As its name implies, this type of bond can be converted later to stock in the company issuing the hybrid security.
There are two types of convertible bonds: holder-option convertible bonds and issuer-option convertible bonds. Holder-option bonds give you the option to turn the bonds into stock, while the issuer-option bond leaves that decision with the company that issued the bond.
Just like a normal bond, convertible bonds have a maturity date. This is the date at which your bond converts to stock in the company.
Convertible Preferred Shares
Close behind the convertible bond in common use is the convertible preferred share. These hybrid securities pay a dividend at a fixed or floating rate. Convertible preferred shares also pay out dividends before common stock in a company and can be traded for the security’s underlying company stock.
Hybrid Mutual Funds
Hybrid mutual funds represent an investing philosophy focused on allocating and correlating assets to diversify your portfolio. The fund invests in more than one asset class (again, combining equity and debt assets) and sometimes includes gold or real estate.
By allocating your money to different asset classes, lowering the correlation in how the assets move and diversifying the overall fund, this approach aims to maximize your returns while exposing you to minimal risk.
In-Kind Toggle Notes
The in-kind toggle note allows the issuing company to toggle from paying interest on the debt it owes you to additional debt. However, the company doesn’t pay the debt immediately.
This type of hybrid security gives the company additional cash flow, but as an investor, you might never see your money if the company can’t overcome its cash flow problems.
Benzinga can provide more information about these and other forms of hybrid securities.
Advantages for Investors
Hybrid securities offer investors three main advantages.
- Higher returns: Hybrid bonds generally offer higher returns than traditional bonds. If the company is doing well and sees an increase in its stock, you’ll hold equity in a growing company.
- Diversification: Hybrid securities allow you to diversify your bond portfolio with one financial instrument, reducing your overall risk.
- Volatility: While volatility is a common risk in investing, it can be an advantage with hybrid securities providing less risk than the pure equity in your portfolio.
Such advantages can make hybrid securities an appealing option to versatile investors and those with unique objectives.
Risk and Considerations
If you’re thinking about investing in hybrid securities, you should take these risks and considerations into account.
Hybrid securities are susceptible to changes in a company’s financial health, regulations or tax treatment. Consequently, you must think about the following.
- Trigger events: A company’s lower earnings could defer interest payments, impacting expected returns.
- Volatility: Market prices for the security can impact your return if it’s trading at a price below the original face value.
- Liquidity: While traded through an exchange, the security won’t have the liquidity of a stock, and it will be harder to move out of your portfolio if the price drops.
- Unsecured: As debt, hybrid securities often aren’t secured against company assets, giving secured and senior debt precedence for repayment if the company goes south.
- Prepayment: Some hybrids can be recalled or redeemed earlier than expected; for instance, if interest rates drop and the company wants to replace higher interest issues with issues at a lower rate.
Hybrid securities can be a good way to diversify your investment portfolio. However, you should understand the risks they present to make sure this type of investment helps move you toward your financial goals.
Special Considerations
By their nature, hybrid securities can be complex, baffling even the most experienced investors as they evaluate their benefits and disadvantages.
Hybrid securities combine the nature of debt and equity assets in one security, offering the potential for a higher rate of return. They also come with a higher risk profile than standard debt and equity securities.
If you're thinking about investing in hybrid securities, you’ll need to weigh several factors, including your risk tolerance, the credit rating of the company issuing the security, the terms and conditions you’re being asked to agree to and the state of the market.
To help mitigate some of these considerations, consider whether you might need the assistance of a financial adviser before diving into the deep end of the investing pool.
Understanding and Taking Advantage of Hybrid Securities
Because hybrid securities are fundamentally complicated, investing in them might take more time than other investments. With the help of a financial adviser, however, you can take steps to diversify your overall investment portfolio while pursuing lower-risk options. This process may help you achieve better returns overall.
Frequently Asked Questions
What is a hybrid bond?
A hybrid bond is similar to a normal bond in that it promises to pay a higher interest rate at a specified time in the future. However, the number and timing of payments aren’t guaranteed, and the bonds can be converted to company stock.
What are the pros and cons of hybrid securities?
A few pros of hybrid securities include the potential for higher returns compared to traditional fixed-income securities, as well as the ability to diversify your portfolio. Hybrid securities can be complex and may require a deeper understanding of the market and financial instruments. They also tend to have lower liquidity compared to more traditional securities, which can make it difficult to sell them quickly if needed.
What are hybrid securities examples?
Examples of hybrid securities include convertible bonds, convertible preference shares, hybrid mutual funds and in-kind toggle notes.
About Sarah Edwards
Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.