Hybridsecurities are a broad group of securities that combine the characteristics of the two broader groups of securities, debt and equity. Hybrid securities pay a predictable 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 underlyingshare. Therefore, unlike with a share of stock, the holder enjoys a predetermined cash flow, and, unlike with a fixed interest security, the holder enjoys an option to convert the security to the underlying equity. Other common examples include convertible and converting preference shares. A hybrid security is structureddifferently than fixed-interest securities. While the price of some securities behaves more like that of fixed-interest securities, others behave more like the underlying shares into which they may convert.
Examples
A convertible bond is a bond that can be converted into common shares of the issuer. A convertible bond can be valued as a combination of a straight bond and an option to purchase the company's stock.
A redeemable, or callable, preferred stock confers the issuer to repurchase the stock at a preset price after a specified date, converting it to treasury stock. Therefore, if interest rates decline, the company has the flexibility to redeem the stock and subsequently re-issue it at a lower rate, reducing its cost of capital.
A PIK loan may carry a detachable warrant – the loan is the debt, while the warrant is the equity
Important terms
Returns: Predictable dividend, often franked therefore possible tax advantage to the holder
Capital price:
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 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.
Redeemable/non-redeemable
Basket D security
The most popular hybrid among financial institutions 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 to roll-over the security at expiry to an indefinite or long maturity bond and to suspend dividends. 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.
