Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt

Debt

A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

 and equity

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

.

Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share.

Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares.

A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.

Examples

• A convertible bond
  Convertible bond
  In finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...
  
   is a bond
  Bond (finance)
  In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
  
   (i.e. a loan to the issuer) that can be converted into common shares
  Share (finance)
  A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
  
   of the issuer. A convertible bond can be valued as a combination of a straight bond and an option
  Option (finance)
  In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
  
   to purchase the company's stock.

• An income security is a hybrid between a stock and a bond. The bond portion pays interest, and the stock portion pays dividends. Income securities are popular in Canada.

• A PIK loan
  PIK loan
  A PIK loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof , thus making it an expensive, high-risk financing instrument...
  
   may carry a detachable warrant
  Warrant (finance)
  In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
  
   (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) – the loan is the debt (Bond), while the warrant is the equity

• The important hybrid instruments are:
  • Preference shares
  • Convertible/exchangeable debentures/bonds
  • Debt with attached warrants

Important terms

• Returns: Predictable dividend, often franked therefore possible tax advantage to the holder

• Capital price:
• Price moves in line with share price (fixed conversion terms e.g. 1 hybrid convert to 1 share)
  
• Bond like, price does not move in line with share price (variable conversion terms, face value (usually $100) convert to $100 worth of shares).

• Discount: A discount is usually offered to the share price at the time of conversion.

• Reset/resettable: At the reset date the terms of the security (dividend rate, next reset date) may change. The holder can elect to accept the new reset terms or convert into shares.

• Cumulative/non-cumulative This refers to the event of missed dividend payments.
• Cumulative: missed dividend payments are added to the next dividend payment.
• Non-cumulative: missed dividend payments are forgone.

• Redeemable/non-redeemable
• Redeemable: At certain times the holder may have the option to sell the securities back to the company at the face value/issue price.
• Non-redeemable / irredeemable: The company is not offering to buy the securities back.

Traditional hybrids

Traditional hybrids were usually structured in a way that leads the securities to react to the underlying share price. Although each has individual characteristics, typically:

• they have a set dividend until conversion
• the conversion might occur at a number of dates
• they are usually issued at a similar price to the underlying share
• they convert at a set ratio. e.g. 1 hybrid converts into 1 underlying share

Note: This fixed conversion ratio means the price of these hybrids react to the movement in the underlying share price. (The extent of the co-relation is sometimes referred to as a delta, and these typically have a delta of between 0.5 and 1)
In addition, some of these securities include minimum and maximum conversion terms, effectively giving the holder a put and call option if the share price reaches a certain prices.

Latest style of hybrids

Most of the hybrid securities issued recently are very bond-like. Although each has individual characteristics, typically:

• they have a set dividend rate for a 5 year period ('reset' period)
• are issued at $100
• the holder has the ability to take the new 'reset' terms, redeem the face value or convert
• the holder can convert into the shares at a discount to the current ordinary share price e.g. 5%
• the conversion ratio is into a dollar amount of shares. e.g. $100 worth of the underlying equity Note: This 'variable' conversion ratio means the price of these hybrids does not react to the movement in the share price, and they therefore behave in a similar way to fixed interest securities (this lack of co-relation with the underlying shares is sometime referred to as a zero delta).

Usage

Hybrid securities have skyrocketed in popularity since Moody's

Moody's

Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...

 released a new set of guidelines for treating debt-equity hybrids in February 2005. The new guidelines establish a "debt-equity continuum" and allow institutions to classify part of the hybrid security as equity and part as debt (in a shift from the previous policy, that counted the entire amount as debt). This change allowed companies to issue hybrid securities at a time of record low interest rates (and thus gain access to cheap capital) and then use the proceeds to repurchase equity shares (which have a very high cost of capital). Since only a fraction of the recapitalization would be listed as debt on the balance sheet, hybrids allowed companies to repurchase more shares than previously without negatively affecting their credit rating.

Basket D security

The most popular hybrid among financial institutions (banks and insurance companies) is the Basket D security. Basket D is a reference to a point on Moody's debt-equity continuum scale that treats the hybrid as 75% equity and 25% debt. In order to qualify, the security must give the issuer the right (or even the obligation) to roll-over the security at expiry to an indefinite or long maturity bond and to suspend dividends (effectively coupon payments, but to reflect the equity nature of the security, the term "dividend" is used). Most Basket D issuances have been structured in a way that also preserves the tax deductible nature of their interest payments, avoiding double taxation/customs.

See also

• Convertible security
  Convertible security
  A convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
  
  
• Convertible debt
• Monthly income preferred stock
  Monthly income preferred stock
  Monthly income preferred stock or MIPS is a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993...
  
  
• SWORD-financing
  SWORD-financing
  SWORD-financing is a special form of financing invented to help young biotech companies access capital to finance their R&D via establishing SPE ....
  
  , a special form of securities used in biotech industry
• Shareholder loan
  Shareholder loan
  Shareholder loan is a debt-like form of financing provided by shareholders. Usually, it is the most junior debt in the company's debt portfolio, and since this loan belongs to shareholders it should be treated as equity. Maturity of shareholder loans is long with low or deferred interest payments...
  
  
• Venture lending