A hybrid security is a single financial product that combines different types of financial securities, or has features of multiple kinds of securities. Typically, this means that the security has aspects of both debt (bonds) and equity (stocks). In this case, the security will have the guaranteed payment nature of a bond while also having the potential for capital appreciation of a stock. We discuss types of hybrid securities as well their pros and cons.
What Is A Hybrid Security?
Letâ€™s start by defining security: a tradable financial product that generates returns based on either the performance of a company or an established rate of return. The two main types of securities are equities (stocks), in which you buy partial ownership of a company; and debt (bonds), in which you lend a company money and receive payments and interest according to a set rate and schedule.
Hybrid securities include components of both security types, and they accomplish what their underlying assets accomplish: they enable an issuing company to raise capital without having either the full commitment of a bond or the exposure of a stock offering.
Example: Convertible Bonds
The most common example of a hybrid security is called a â€œconvertible bond.â€ This is a bond that comes with an option to convert the instrument into a different type of security at a future date. Ordinarily the bond will convert into shares of stock in the issuing company.
This makes the convertible bond a hybrid security. It has the interest payments and guarantee of a bond, but its value also depends on the asset underlying the bondâ€™s conversion option. Again, in a typical case, this means that the bondâ€™s value is influenced by the companyâ€™s stock price.
Convertible bonds typically come in two forms: holder options and issuer options. In a holder-option bond, the investor who owns the bond can choose whether to convert the bond into shares of stock. In an issuer-option bond, the company which issued the bond can choose whether to convert it into shares of stock. Holder option bonds generally pay lower interest rates than issuer option bonds because the investor can choose to convert the bond if the companyâ€™s stock goes up.
Convertible bonds are based on a maturity date. This is the point at which either the investor or the issuer (depending on the nature of the bond) can convert it into equity. They will also come with what is known as a â€œstock conversion price.â€ This is the price at which the bond will convert into equity.
So, for example, say ABC Co. issues a convertible bond set to its own stock with a five-year maturity, holder-option and a stock conversion price of $20. You purchase a $1,000 bond. This means that in five years you will have the option to convert this bond to common stock based on the value of the bond and the stock conversion price. Here, you can convert the bond to $1,000/$20 = 50 shares of ABC Co. stock.
Example: Convertible Preferred Shares
Convertible preferred shares, also known as convertible preference shares, are a specialized form of security that comes with the option to convert into either common shares of the company or a cash payment, depending on the specific asset.
Like most preferred shares, convertible preferred shares come with secured dividend payments. Unlike common stock, which issues dividends on an as-approved basis, preferred shares will typically have a guaranteed schedule of dividend payments. These can have either a fixed or floating basis, but the regular payments create a bond-like aspect to this security.
The ability to cash in the convertible preference shares also shares its nature with a bond. At the assetâ€™s maturity date you are guaranteed some form of payment, whether in cash or common stock.
However, at the same time the value of the preferred shares is based on the firmâ€™s stock price, making this an equity instrument as well as a bond-like one.
Hybrid Securities: Risks and Rewards
Generally speaking, hybrid securities are considered higher risk than the bonds or stocks that they incorporate. They tend to have less liquidity than a stock, making it harder to move a bad investment in and out of your portfolio. Meanwhile, they have more market exposure than a bond, making them less reliable.
Yet this can still be a very useful investment for the right portfolio. In particular, because of their greater risk profile, a hybrid security will generally have a higher rate of return than an otherwise comparable bond.
These are generally considered more suitable for institutional investors than retail investors. Hybrid securities tend to have a complicated, risky profile and arenâ€™t a good fit for the average portfolio. However, if you are interested, funds that incorporate hybrids into their investment strategy can add some potentially useful diversity to the right portfolio.
The Bottom Line
A hybrid security is one that incorporates parts of multiple different types of securities. Most often they involve aspects of both debt and equity instruments, creating a higher rate of return but also a greater risk profile than an ordinary security.
Tips for Investing
A financial advisor can help you understand the role hybrid securities can play in your investment portfolio. Finding the right financial advisor who fits your needs doesnâ€™t have to be hard. SmartAssetâ€™s free tool matches you with financial advisors in your area in five minutes. If youâ€™re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
The mix of stocks and bonds in your portfolio is referred to as your asset allocation, and that determines how much risk and return your investments are subject to. Use our asset allocation calculator to find the best allocation for you.
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