Hybrid instrument

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).

Examples of Hybrid instrument

• Convertible bonds: A convertible bond is a type of hybrid security that combines the features of both debt and equity. It is a debt instrument that gives the bondholder the right to convert the bond into a predetermined number of common stock shares at a specific price.
• Preferred stocks: Preferred stocks are hybrid securities that have both debt and equity features. They offer the potential for some appreciation in value, like stocks, but their dividend payments are fixed, like bonds.
• Exchangeable bonds: Exchangeable bonds are hybrid securities that combine the features of a bond and an equity security. They are bonds that can be exchanged for a specified number of shares in another company at a predetermined price.
• Equity-linked notes: Equity-linked notes (ELNs) are hybrid securities that combine the features of both debt and equity. They are debt instruments that are linked to the performance of an underlying equity.

Limitations of Hybrid instrument

• Hybrid instruments are subject to more fluctuations in value than traditional debt securities, due to the added element of equity risk.
• They may also have higher levels of complexity than other traditional securities, making them less accessible to smaller investors.
• Additionally, hybrid instruments may be subject to higher levels of taxation than other traditional securities.
• Hybrid instruments may also have debt characteristics that are not appropriate for all investors.
• Furthermore, hybrid instruments can be difficult to value since there is not always an active market for them.
• Lastly, the potential for increased returns are often accompanied by increased risks, making hybrid instruments a risky investment choice.

Other approaches related to Hybrid instrument

Apart from the traditional hybrid instrument, there are other approaches related to hybrid security.

• Convertible bonds - these are corporate bonds that can be converted into a predetermined number of shares of the issuer’s common stock.
• Exchangeable bonds - these are corporate bonds that can be exchanged for equity shares of another company, usually one that is closely related to the issuer.
• Mandatory convertible notes - these are bonds that must be converted into equity at maturity.
• Contingent convertible bonds - these are bonds that must be converted into equity in certain circumstances, such as when the issuer’s share price falls below a certain level.
• Equity-linked bonds - these are bonds that pay dividends based on the performance of the issuer’s share price.
• Warrants - these are securities that grant the holder the right to purchase a predetermined number of shares of the issuer’s common stock at a predetermined price.

In summary, hybrid instruments are securities that combine elements of debt and equity securities. Examples of such instruments include convertible bonds, exchangeable bonds, mandatory convertible notes, contingent convertible bonds, equity-linked bonds and warrants.

Hybrid instrument — recommended articles

Bonds in finance — Mezzanine capital — Equity instrument — Equity interest — Distribution In Kind — Redeemable shares — Pledged asset — Quoted investments — Property Dividend

References

• 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