Hybrid instrument (also known as hybrid security) is a type of security which link a few features of debt securities with any features of equity securities. Hybrid financial security combining two components, equity and debts, that can be defined as bond with equity features but also as share with debt characteristics.
The term could also be used more generally when relating to any financial instrument which linkes features of at least two financial instruments. It should be remembered that the financial innovation expected by a few different hybrid options connected to instruments between equity and debt, they are hardly recognized on the financial market. This happens because they sometimes have equity’s features and frequently debt’s features (F. Bruno, A. Rozzi 2014).
The most popular form of this instrument is the convertible bond. This kind of security is an emission of debt and it can be changed to a firm's common stock at any time. The main advantage of this type of instrument is if the company's stock price fall, the option will not be processed and it will be possible to still gain interest payments on bonds.
Types of Hybrid Instruments
One of the most popular types of hybrid instruments are:
- convertible bonds - one of the most popular type of hybrid instruments. Companies issue them to encourage investors with the opportunities of higher return. The holders of this type of hybrid instruments are authorized to convert each bond for some sheres of common stock when the stock increase in value. Convertible bonds also brings profits to the company because issuance is more quicker and the new capital does not affect the firm’s earnings. Also the owners pay less interest on this types of convertibles.
- convertible preferred shares - it is another types of hybrid security. Similar to the above discussed they retain a lower risk profile but also have a possibility of higher return when they are changed to common stock for capital growth.
- mezzanine financing - is a form a financing which that functions by using two other methods. It is an agreement in which funds are granted in a traditional loan. However the lender may take over the property if the loan is not paid full and on time. Lender who provides this kind of hybrid instrument usually search for company who has a possibility to grow, if equipped with proper additional capital (J. Way 2019).
Benefits of Hybrid Security
Hybrid security have many advantages, among others they are:
- Hybrid securities combine features of financial instruments which includes equity and debt commitments.
- Hybrid instruments are used safeguard creditors and depositors of a financial institution which is managed to offer a capital pillow to prevent any unexepcted losses coming from any operations of the issuer.
- One of the main advantages of this kind of instruments is that they are cost effective it is available to structure coupon payment so they are tax deductible.
- They are two main advantages to an issuer. First is that the finance is long term and the second one is connected with the cost effective when related to issuing shares to gain capital (J. P. Green 2012).
Risk of Hybrid Security
Hybrid instruments have higher risk then other types of debt payments. Most common risks are:
- Trigger events - the investment features and returns depend on their occurrence. The examples of this type of events are lossing of earnings which cause the postponement of interest payments and changes in a tax laws or regulatory requirements.
- Market price volatility - it is another risk of hybrid security because the market price may fall below the price investor paid for it. This can happen if company suspends or rejects interest payments or its performance decline.
- Liquidity risk - most hybrids are usually less liquid then shares. This means that on the market are only a few buyers and sellers for this type of financial investments so it is very likely that if you want to sell your investments quickly you will have to do it for a lower price.
- Subordinated ranking - hybrid inestments are often unsecured and that means that the compenstaion is not secured over asset. If company which issuing the security turn into insolvent you will be the last one to get your money back (Hybrid Security and Notes 2019).
- Bruno F., Rozzi A. (2014). The Hybrid Financial Instruments in Italy: A first attempt to define this category, "International In - house Counsel Journal”, (Vol. 7, No.28).
- Green P. J. (ed.) (2012). Hybrid Securities: an overview, "Capital Markets", Morrison & Foerster LLP.
- Hybrid Security and Notes (2019), "Australian Securities & Investments Commission".
- Van Gelder G., Niels B. (2013). Tax Treatment of Hybrid Finance Instruments, "Derivatives & Financial Instruments", 140-147.
- Way J. (2019). Types of Hybrid Security, "PocketSense".
Author: Hanna Cugier