A hybrid security is a single financial item that integrates varied types of financial securities or has characteristics of multiple types of securities. Typically, this implies that the security holds features of both equity (stocks) and debt (bonds). In this scenario, the security will offer an assured payment nature of a bond while also carrying the ability for capital appreciation of a stock. Let us learn more about this security in detail.
What Is A Hybrid Security?
Let us begin by defining security which is a tradable financial product that develops returns based on either the company’s performance or an established rate of return. The two primary types of securities are equities which are stocks in which you purchase partial ownership of an entity and the other is debt which are bonds, in which you lend an entity money to get payments and interest as per a set schedule and rate.
Hybrid securities characteristics also include components for both security types and they attain what their underlying asset accomplishes. They allow an issuing entity to raise capital without having either complete commitment of a bond or the exposure of a stock offering.
Types Of Hybrid Securities
Along with convertible bonds, another famous type of hybrid security is convertible preference shares, which offer dividends at a floating or fixed rate before common stock dividends are paid, and they can be exchanged for shares of the underlying stock of the company. This is another hybrid securities example.
“Pay in kind” toggle notes another form of this security where the issuing entity can toggle the payment from the rates of interest to the added debt owing to the investor, implying the entity owes the investor more debt but does not actually pay immediate interest. This interest deferral enables the company to keep the cash flowing but the greater principal payment may never arrive if the cash flow situation is not resolved.
Every type of this security has a unique reward and risk feature. Convertible bonds provide greater potential for appreciation compared to regular bonds, but pay less interest compared to conventional bonds, while still encountering the risk that the underlying entity could perform poorly. They can also fail to enable coupon payments and not be able to repay the face value of the bond at maturity. Convertible securities provide greater income potential compared to regular securities but can still lose value if the underlying entity underperforms. Other risks of hybrid securities are insolvency, market price volatility, deferred interest payments, early repayment, and illiquidity.
Risks And Rewards Of This Security
Let us now have a look at advantages and disadvantages of hybrid securities. Normally speaking, hybrid securities are believed to have higher risk compared to the stocks or bonds that they incorporate. They tend to have less liquidity in comparison to a stock, making it harder to move a bad investment in and out of your portfolio. At the same time, they have more market visibility than a bond, making them less reliable.
Yet this type of stock can still be a very useful tool of investment for the right portfolio. In specific, because of their higher risk profile, a hybrid security will mainly have a higher rate of return compared to an otherwise comparable bond.
These are generally thought more suitable for institutional investors compared to retail investors. Hybrid securities tend to have a complex, risky profile and are not a good fit for the average portfolio. However, if you are inclined towards this, funds that incorporate hybrids into their investment strategy can add some very useful diversity to the right portfolio.
The Bottom Line
A hybrid security is one of the stocks that incorporates parts of several varied types of securities. Most often they involve dimensions of both equity and debt instruments, formulating a higher rate of return but along with that they also have a greater risk profile compared to any ordinary security.